Author: Vera Chang, District Manager of General Mortgage Capital Corporation
Posted on 6/15/2024
When client locking the rate, a very frequent asked question: which is better, a 30-year mortgage or a 15-year? Is the 15-year mortgage much more cost-effective because you pay a lot less interest compared to a 30-year mortgage, where most of the early payments are just interest?
The answer is NO!
Today, Vera will analyze this question in detail and give you the clearest, most comprehensive answer!
If you’re short on time or get dizzy looking at numbers, you can skip to the conclusion at the end of the article.
Before we start, let's clarify one concept: how is loan interest calculated?
Simply put, the method for calculating loan interest is the same as for deposits:
Beginning of the month balance X (annual interest rate / 12) = interest for the month.
For example:
If the loan balance at the beginning of the month is $1 million with an annual interest rate of 6%, the interest owed for the month is $1 million X 6% / 12 = $5,000.
If you repay a total of $500,000 of the principal this month (including the regular monthly payment principal and any extra repayment), then the interest owed for the next month is (1 million - 500,000) X 6% / 12 = $2,500.
Pay attention to the extra principal repayment part, as this is key to what we will discuss next.
First, let’s look at how interest and principal are distributed in monthly payments for a 30-year fixed-rate loan.
To explain, let’s take a $600,000 loan with a 30-year term at a 6% interest rate, resulting in a monthly payment of $3,600 (excluding property taxes, insurance, HOA). For the first 18.5 years (222 months), the principal portion of the monthly payment is lower than the interest. From the 223rd month onwards, more than 50% of the monthly payment goes towards the principal, as shown in the table below. Many people have seen similar tables, leading to the impression that in the early years of a 30-year mortgage, you’re mostly paying interest.
Figure 1: 30-year mortgage monthly principal and interest payment trends and comparison
If we break down the first year's payments, we see that only about 17% of the payments go towards the principal.
Table 1: Monthly principal and interest payments for a 30-year mortgage - First 12 months
Now let’s look at a 15-year mortgage If the interest rate is also 6%, the monthly payment would be $5,066. For the first 3.5 years (42 months), the principal portion of the monthly payment is lower than the interest. From the 43rd month onwards, the principal portion starts to exceed the interest, as shown in Table 2.
Figure 2: 15-year loan monthly principal and interest payment trends and comparison
Breaking it down, in the first year, the principal portion averages as high as 42%.
Table 2: Monthly principal and interest payments for a 15-year mortgage - First 12 months
From the principal/interest ratio perspective, it’s true that a 15-year mortgage is more cost-effective.
However, when comparing total monthly payments, $3,600 for a 30-year mortgage versus $5,066 for a 15-year mortgage, there is a difference of $1,466. To make an apple-to-apple comparison, we need to equalize the monthly payments for the 30-year and 15-year loans. This means adding the extra $1,466 to the regular monthly payment of the 30-year loan to repay the principal. If we do this, what happens?
Due to space constraints, Vera cannot show the repayment situation for all months. However, using the first 12 months as an example, you can see that by the end of the 12th month, the remaining balances of both the 30-year mortgage and the 15-year mortgage are identical at $574,550. Thus, by accelerating repayment each month, the actual repayment term becomes 180 months instead of the planned 360 months.
Table 3: Monthly principal and interest payments for a 30-year mortgage with extra principal repayment - First 12 months
Conclusion
When the interest rates for 30-year and 15-year mortgages are the same (which is currently the case for most investment properties), choosing a 30-year mortgage is better because:
By adding some extra principal to the monthly payments required by the bank, the final result of a 30-year mortgage equals that of a 15-year mortgage - as discussed above.
A 15-year mortgage greatly reduces borrowing capacity since the required monthly payment is high, whereas the 30-year monthly payment is low. If you plan to buy more properties in the future, having lower monthly debt increases your borrowing capacity.
A 30-year mortgage offers more flexibility: you can adjust your monthly repayment amount, and in months where you need to spend more, you can revert to the bank’s required basic monthly payment.
When the 15-year mortgage interest rate is lower than the 30-year rate (which is currently the case for most owner-occupied homes), choosing between a 15-year or 30-year mortgage depends on your future plans:
If the interest rate difference is more than 0.25%, consider a 15-year mortgage.
If you plan to refinance in the near future, consider a 15-year mortgage because you can choose between 15-year or 30-year options when refinancing.
At this point, you should have a new understanding of these two types of loans. It’s not easy to fully grasp the intricacies of loans, but with Vera here, feel free to reach out with any questions at (347)-688-9191.
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