When you buy a home, you most likely have to research your options for mortgage loans and pick one that makes sense for you. Unfortunately, this is easier said than done. That’s because whenever you select a mortgage loan, there’s a big tradeoff you have to consider. Here’s what it is.
This is the biggest tradeoff mortgage borrowers have to make
When you pick your mortgage, you are going to have to decide between:
- Lower monthly payments, but higher costs over the life of the loan
- Higher monthly payments, but lower borrowing costs over the life of the loan
Mortgages come in different term lengths. The most popular options are a 15-year mortgage or a 30-year mortgage, although there are also others such as a 20-year loan.
A 15-year mortgage generally has a lower interest rate compared with a 30-year mortgage because this kind of loan is less risky for the bank. You always pay less with a lower interest rate. But that’s especially the case when you cut 15 years off your payoff time since you are going to be paying interest for much less time. But, by making half the number of payments, it’s obviously necessary for each individual payment you make to be much bigger.
A 30-year loan will come with a higher interest rate, and obviously you are going to pay interest for many more years, so costs will be greater over time compared with the 15-year loan. But the monthly payment will be much more affordable since you are going to have twice as long to pay your balance off.
To understand this tradeoff, let’s look at an example. Say you are borrowing $400,000. In this case, you might find yourself deciding between a 30-year loan with an interest rate of 5.5% or a 15-year mortgage with an interest rate of 4.7%.
The 15-year loan would cost you $3,101 per month for your mortgage principal and interest (not counting property taxes and insurance). And you would pay a grand total of $558,183, so $158,183 in interest costs. But the 30-year loan would come with monthly principal and interest payments of $2,271 and total costs over time of $817,616, so you would pay $417,616 in interest costs.
Which option is right for you?
When it comes to this tradeoff, the right answer depends on your goals and your overall financial picture.
Some people want to be debt-free ASAP and would prefer the 15-year mortgage even though that means making much higher monthly payments (and potentially finding it more difficult to qualify for the loan because of it). This is the kind of loan that finance expert Dave Ramsey recommends.
Other people would be better off taking the more affordable loan and investing the money they save on their monthly mortgage payment. The return you get from early mortgage payoff is just the interest saved, so you can likely get a better rate of return by opting for a 30-year loan and investing the difference that you save. But you need to be sure you’ll use the money you save responsibly — otherwise, a 15-year loan may be the better bet if you can afford it.
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