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That 30-year mortgage might not be your best option

  • One plus of a 30-year mortgage is a lower monthly payment, which frees up cash for other financial goals.
  • Two strikes against such loans is that borrowers will pay more overall and will more likely have debt later in life.
  • Fifteen-year mortgages flip the script, lowering costs and shortening loan terms but tying up more cash and restricting investors' ability to buy stocks and other interest-paying vehicles.

The 30-year fixed-rate mortgage is the most common way Americans attain homeownership. It's so commonplace that most people seem to take for granted that it's the best option for them. But putting yourself on the hook for 30 years is a big deal and should be treated as such. It's certainly not your only option.

Let's run through the main pros and cons of a 30-year fixed-rate mortgage.

Interest rates on 15-year mortgage terms are typically lower than those on longer-term loans because the shorter duration of the loan makes it less of a risk to the lender.
LWA/Dann Tardif/Blend Images | Getty Images
Interest rates on 15-year mortgage terms are typically lower than those on longer-term loans because the shorter duration of the loan makes it less of a risk to the lender.

Pros:

  • Lower monthly payments. This is a pretty obvious advantage of a 30-year loan term versus shorter loan terms. Stretching the repayment of the loan out over a longer time means you can pay it down in relatively small chunks. This allows you to have more money left over each month to spend or save on other things.

  • Opportunity to put extra cash flow toward other financial goals. An upshot of having lower monthly payments is that you can use the extra cash flow to further other personal financial goals, such as funding college savings plans for your children or saving more in retirement accounts.

    Considering the fact that interest rates are relatively low currently and that mortgage interest is deductible, your effective after-tax mortgage rate will likely be quite low. If you invest your extra money in stocks or use it pay down higher interest/non-deductible debt, it is likely you will come out ahead over the long term.

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Cons:

  • You pay (much) more overall. If you run the numbers comparing a 30-year mortgage with a shorter-term mortgage, the lower monthly payments on the 30-year option make it look more affordable. But it's actually much more expensive overall. With a 30-year loan, you will typically end up paying over twice the amount of interest you would with a 15-year loan term.

    This is because you are paying to borrow money for twice the time and lenders charge higher interest rates to lend you money for longer periods of time (you have to compensate them for taking extra risk). This frequently means a six-figure difference in total payments. Though, as discussed above, this is slightly offset if having lower monthly payments allows you to invest the difference at a much better return.

  • You will likely still have debt relatively late in life. One of the best things you can do to have financial security in retirement is to retire without debt. Having to make debt payments while simultaneously having no earned income is not a good combination, for obvious reasons. Having a 30-year mortgage makes it much less likely that you will be debt-free at retirement age.

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Now let's review the pros and cons of a 15-year fixed-rate mortgage.

Pros:

  • Owning your home will cost you much less overall. Interest rates on 15-year mortgage terms are typically lower than those on longer-term loans because the shorter duration of the loan makes it less of a risk to the lender. However, even with interest rates being equal, paying interest for 15 years rather than 30 years will still save you a lot of money overall. If you run the numbers on a mortgage calculator, this becomes very clear.

  • You could have a paid-off home by the time your kids graduate from high school. As I mentioned above, being debt-free at retirement is vital for financial stability. With a 15-year loan term, you may be debt-free well before retirement. This also does wonders for peace of mind.

Cons:

  • Tighter cash flows during the loan term. Although you will pay much less overall taking a 15-year mortgage versus a 30-year mortgage, the monthly payments on the 15-year will likely be quite a bit higher. After all, you're paying the same amount of principal in half the time. That being said, you will probably feel quite rich once the mortgage is paid off.

  • Opportunity cost. Assuming that you could invest the extra cash flow you would have by taking a 30-year mortgage in the stock market or elsewhere for a better return than your after-tax mortgage rate, then there is an opportunity cost to opting for higher monthly payments with the 15-year mortgage. However, investment returns are never a sure bet. The return on paying down your mortgage is something you know for certain.
"If you are a potential homebuyer, don't just assume that a 30-year mortgage is your best bet because the monthly payments are lower."

You may want to try a combination of both. With this strategy, you take out a 30-year mortgage but plan to put extra payments toward principal over the loan to pay it off sooner. There are many ways to do this (putting extra toward principal each month, putting big chunks down here and there), but the bottom line is that you throw extra money at the mortgage principal whenever you can. If you do this, you will pay the mortgage off early and save money in the process.

However, you still have the flexibility of making just the lower required payment if cash flows get tight. If you plan to do this, you must make sure your loan contract specifies that there are no prepayment penalties.

So if you are a potential homebuyer, don't just assume that a 30-year mortgage is your best bet because the monthly payments are lower. As you can see, picking the right mortgage term for your financial situation is complicated.

What's important is that you consider the pros and cons of multiple home-financing options before you make any big commitment.

(Editor's note: This guest column originally appeared on Investopedia.)

— By Rachel Podnos, financial planner at Wealth Care

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