When applying for a mortgage, there are few more important decisions you’ll need to make than your repayment term. A repayment term, also known as loan term or loan duration, determines how long you have to pay off the loan. Mortgage repayment terms generally range from 10-30 years, and the most common are 15-year mortgages and 30-year mortgages.
All other things being equal, a longer repayment term lowers your monthly payment but increases the total amount you pay the lender over the life of the loan. A shorter repayment term increases your monthly payment but lowers the total amount you pay the lender over the life of the loan.
Before we can do a proper comparison of 15-year mortgages vs. 30-year mortgages, we first need to look at how the repayment term affects your interest rate.
Because 15-year repayment terms are less risky to lenders than 30-year repayment terms, they usually come with lower interest rates.
How big is the difference in interest rate between repayment terms? Well, it depends on the lender as well as the lender’s assessment of your borrowing profile, e.g., your credit score, income, etc.
Based on Freddie Mac’s records of average mortgage interest rates from the past five years,15-year terms are typically 0.5% to 0.75% cheaper than 30-year terms. On April 15, 2021, the average interest rate for a 15-year fixed-rate mortgage was 2.35% and the average interest rate for a 30-year fixed-rate mortgage was 3.04% - giving the shorter repayment term a 0.69% advantage.
A search of interest rates at some of America’s top mortgage lenders reveals a similar picture. For example, on April 20, 2021, Better Mortgage was advertising a minimum 1.875% for 15-year fixed-rate mortgages and 2.500% for 30-year mortgages – a gap of 0.625%. Quicken Loans was advertising 2.375% for 15-year fixed rate mortgages and 3.125% for 30-year mortgages – a gap of 0.75%.
Your monthly mortgage payments are actually determined by three factors: your loan amount, interest rate, and loan term. For the purposes of this comparison, we’ll use a loan amount of $314,640 (calculated from the $393,300 average sales price of a house sold in Q4 2020 minus 20% down payment) and the national average fixed interest rate of 2.35% for a 15-year term and 3.04% for a 30-year term.
As the above table shows, a 30-year repayment term gives you a substantially lower monthly payment – even though the interest rate is higher. However, it can translate to a much higher overall price for your mortgage. In this example, a 30-year fixed-rate mortgage costs $104,348 over the life of the loan than a 15-year mortgage.
If, for hypothetical’s sake, you were offered the same interest rate for both repayment terms, the 15-year term would have an even higher monthly payment than the 30-year term – but would still come out much, much cheaper overall. For example, if we increase the rate on the 15-year term to 3.04%, it becomes around $17,000 more expensive than previously, but is still around $87,000 cheaper than the 30-year option.
The numbers give the answer: a 15-year term is better than a 30-year term, as long you can afford the monthly payments.
To calculate how much you can afford to pay on your monthly mortgage payment, a useful rule to follow is the 28/36 rule, which says a household should spend no more than 28% of its gross monthly income on total housing expenses and no more than 36% on total debt payments, including your mortgage and other debts such as auto loans and credit cards.
The highest possible debt-to-income ratio permitted by lenders is 43%, although lenders generally prefer it be no more than 36% - as in the rule just described.
Of course, you know more about yourself and your future financial prospects than your lender, so never commit to a monthly payment that you don’t think you’ll succeed in paying every single month for the duration of the loan. If in doubt, it’s better to go for a longer repayment term with a lower monthly repayment rather than a shorter repayment term where you risk the possibility of missing future payments (which can lead to penalties and, in the worst-case scenario, foreclosure of your home).
If you’re on the fence, then you also have the option of compromising with a 20-year or 25-year term.
Choosing the best repayment term is just as important as choosing the ideal loan amount and best lender. When applying for a mortgage, check out how the interest rates for 15-year terms and 30-year terms stack up against one another. Then use a mortgage calculator (most lenders offer this for free on their website) to run the numbers and decide which repayment term makes most sense for you.