15, 20 or 30 Year Mortgage Amortization (Payback Period)
With interest rates again at historic lows, many property owners–including us–are looking to refinance their homes. If the last 2 years have taught us anything, it’s that a fixed rate mortgage is the way to go in an uncertain housing market. Sure, adjustable rate mortgages (aka ARM loans) are appealing for their low initial interest rate, but they lack the security of their fixed rate counterparts. In 2009, it’s not been uncommon to end up underwater in a mortgage due to dropping home values. We think it makes sense for better than 90% of the population to be in a fixed rate position in this environment.
Of course, fixed rate loans are not all created equal. Some loans will require the seller to pay a percentage of the loan value to the underwriter at closing (called paying points). Other loans will require a fixed payment to the underwriter (called an origination fee or processing fee). Terms can vary widely in mortgage products, and it’s certainly important to understand the nuances of each loan product you investigate.
Amortization – The Payback Period Explained
One not-so-nuanced feature of a loan is its payback period, or amortization schedule. As most of us already know, the payback period on a loan directly affects the monthly payment. Shorter payback periods (e.g., 15 year loans) mean higher monthly payments, since the principal on the loan has to be paid back quicker. In fact, the difference in required payment amount between a 30 and a 15 year loan, is always 40.75% (note that this percentage is calculated before property taxes and insurance costs).
So, if your payment on a 30 year loan is $1500/month, where $500 of the payment goes to taxes and insurance and $1000 goes to principal and interest, you can roughly estimate that a 15 year loan with the same terms would cost you $1000+$407.50+$500 = $1907.50/month.
Why Take A Shorter Payback Period (e.g. a 15 year loan)?
So if the payment is higher, why would anyone take a shorter loan?
The only reason you should accept a shorter payback period is if the bank offers you a lower interest rate. Here’s why: traditional mortgages in the U.S. have no prepayment penalty. In other words, you can pay off as much of the loan as you want at any time. If you can get the same interest rate for a 15 and a 30 year mortgage, you should take the 30 year mortgage and simply recalculate the amortization schedule yourself and make the payments like the mortgage is only for 15 years. Why? Because if you run into financial hard times in the future, you’ll have the flexibility to move down to the lower 30 year payment.
In the past, shorter amortization periods always featured lower rates, but not so anymore.
Interest Rates on Shorter Loans Aren’t Always Lower
Take a look at this chart from Wells Fargo’s Current Rates Page:
Notice that a 20-year mortgage actually has a higher interest rate than it’s 30-year counterpart! It would be foolish to take a 20-year loan in this situation. Instead of getting a 20 year mortgage, a buyer should always get the 30-year mortgage and simply overpay the loan each month.
Consider Taking a 30 Year Loan Even if You Can Afford More
Notice that the difference in price between a 30 year and 15 year loan from Wells Fargo is only .25%. While the 15 year is cheaper, with such a small difference we think it makes much more sense to take the 30 year loan and simply overpay each month.
In order to avoid getting used to the lower payment requirement, as soon as you close the loan you should have the lender setup automatic drafts from your checking account at the higher payment rate. That way, you don’t get tempted to spend the extra income you should have been applying to the mortgage. But, if hard times come in the future, you can always go back to the lesser payment until you get through the situation.
Quick Payment Math Comparison Calculations
Ignoring insurance and taxes, which do not change relative to the payback period on the loan, the following percentages can help you make a quick affordability comparison of your own loan:
- 10 Year Loans Require an 85% higher payment than a 30 year loan.
- 15 Year Loans Require a 41% higher payment than a 30 year loan.
- 20 Year Loans Require a 20% higher payment than a 30 year loan.
You can also uses these percentages to pay down your home quicker. Want to pay off your 30 year loan in 15 years? Simply make payments that are 41% higher than required and you’ll do just that.
What do you think? What loan payback period did you choose?
Comments & Conversation on this Article...
10 Responses to 15, 20 or 30 Year Mortgage Amortization (Payback Period)
Wait! Got a question on your own project?
Ask your question in our Home Improvement Help Forums.
Otherwise, leave a note here!
March 17th, 2009 7:59 am
We just closed on our refinance last Friday. We ended up with a 30 yr fixed loan at 4.875% with an APR of 4.908%. Our previous loan was at 5.875% with only 3 more years fixed before it went variable. Now is a great time to refinance as it’s very likely interest rates will skyrocket in the coming years after the recession ends as it did in the 80’s.
March 17th, 2009 9:57 am
Fred,
I have to respectfully disagree about pre-paying the loan. If you have the extra cash to pay towards the principal on your loan, I say you should invest it. The interest rates on these loans are so low, I believe the market will return greater than 5% over the long haul.
The reason our parents and grandparents told us it might be a good idea to pre-pay is because they were so anxious to pay back that mortgage due to the way mortgages were handled in the great depression. Back then, banks could come to you and request full payment of a loan at any time. That’s why so many lost their homes back then, and vowed to never owe anything. Regulation has prevented them from doing that so now there’s so much of a tax advantage to having a mortgage, I say, you should reap that benefit!
The case in more liquid investments now is far more appealing to me.
We’ll be looking to refinance soon.. into a 30yr. fixed from a 5-1 ARM.. it worked out perfectly for me, having 4.5% for the last 5 years. I think ARMs are good when you think you could be moving in 5-10 years. We’re planning on staying in the neighborhood for a while though…
~Beth
March 17th, 2009 5:45 pm
When I refinanced 3 years ago I went with 30 years, because 15 was not much better on the interest rate. I wanted the flexibility of lower payments, just in case of emergency. I figured I could add to the principal payment to pay if off in 15-20 years if finances were good.
I did pay additional on the principal for the first 2.5 years, but now I’m saving the money in a separate account. With the current state of the economy, I feel better having extra money in an emergency fund, rather than a lower principal balance for the moment.
We plan to sell this house & buy another in the next couple of years. I will probably get another 30 year mortgage, but will prepay on the principal to reduce the mortgage period. I do want to have a paid off mortgage someday…
March 17th, 2009 7:31 pm
It’s mind numbing how much mortgage strategies have changed in a year. Normally, I agree with taking a longer term and prepaying as much as possible, as that’s an investment with a guaranteed return of 4.875% for your 30 year example. However, if you think that significant inflation is looming, you’re better off to avoid prepayment, so you can pay later in devalued dollars. Of course, if deflation continues, you’re essentially renting because of the equity loss due to the price decline. I think I’m going to settle with moving into a PODS container.
March 17th, 2009 9:10 pm
Really great thoughts on this – thanks for weighing in.
Beth, I agree with you that achieving a better than 5% return is quite possible, but that doesn’t take into account the risk levels of the investment. To compare apples to apples, you would need to compare paying down a mortgage (a guaranteed return) with another guaranteed investment (the most common choice being the 10 year T-Bond). Right now, the mortgage paydown fairs very well in this comparison, as the T-Bond is at 2.98% today.
I wrote an extensive article on the topic here:
http://www.oneprojectcloser.com/finance/mortgages/pros-and-cons-of-paying-down-your-mortgage-early/
In that article, I argue that mortgage pay down makes an excellent conservative investment, and it’s one avenue Kim and I use to balance our otherwise aggressive portfolio (which focuses on large/small stock equities and international stocks)… Also, there are psychological benefits to living debt free. That’s certainly a subjective issue, but I’m willing to give up a few dollars in return to achieve that.
I’m sure at least one place you and I would agree is that you shouldn’t overpay your mortgage until you ensure you’re getting your full 401K match (since that’s free money from many employers).
Diane, I think you’re in good company with that stance. Our emergency fund is a little low right now. We’re going to be using our tax return to bolster that a bit, as well as pay down some other debt.
1ShotRising, You are absolutely right that if inflation continues, it makes more sense to pay with future dollars. However, that assumes that you are protecting those dollars in the meantime – otherwise they are subject to getting hosed by the same inflation that will make your future payments ‘cheaper’. Right now, inflation-protected T-Bonds are returning almost nothing in the market.
Note that if at some point in the future the total after-tax return on T-Bonds exceeds our mortgage rate, we’ll buy T-Bonds instead. That’s truly trading apples for apples, and it would make more sense.
March 17th, 2009 9:45 pm
I totally agree with you on sticking with 30 year fixed loan. We are paying off extra when we can. Love the flexibility. That would eventually lead us to less-than-30-year loan. That seems to be the smartest way to do that under this economy. And do it when you can. Even you saved some interests by ARM, what if you lost job when you plan to refinance?
Btw, I have something about loan fee always wondered about. Hope you can help me… Or could you feature about this in your article sometime?
Usually our monthly payment includes payment to principle/interest, property tax , home insurance, and escrow fee.
If we are willing to pay property tax on our own, can we save the money for escrow??? Or will loan company (ours happens to be Wells Fargo) most likely require us to have escrow company??
What I understand about escrow is that they are 3rd party between us and mortgage company. They have a trust account in our name to pay obligations such as property taxes and insurance premiums. If that’s so, we are willing to do that part instead of paying lots of money for escrow company.
What I don’t know very well is that will we be considered as not-so-safe client to rend money? or it’s not safe for us to deal with large amount of mortgage without escrow company involved?
March 18th, 2009 6:10 am
@ C – We just refinanced and ended up paying a small fee to guarantee that we did not have to escrow funds. We would rather save our taxes in our savings and pay it when it comes due. Some mortgage lenders allow this flexibility, while others do not.
March 18th, 2009 11:27 am
@Todd – I did not realize that this was even an option – and maybe it’s not with my mortgage company, but I will check.
Earlier on, when I was struggling as a single parent with debt & financial difficulties I would not have risked doing this, as I was safer having them collect & hold the money to pay these expenses.
Now I would rather hold my own money & collect interest on it. That would be so easy with my ING savings, to just have it automatically deposited in a special account each month. The interest is at ING is only about 1.65% right now, but still something…
This is definitely a question I will ask when I choose a mortgage lender for my next house!
March 18th, 2009 11:56 am
@Todd,
Thanks for your info! It’s great to know that we may have option not to pay for escrow fee!
At this moment, we decided not to refinance since we have 5.5% (paid for points 3.5 years ago), just payed off the points fee last November. Also I am not working at this moment, not sure how Bank will take it (risky/safe) with single income(my husband).
But I will ask them anyway if they have option like you had. Thank you again!
March 18th, 2009 7:10 pm
@ Diane & C – Most lenders will not tell you about the escrow thing. I told my mortgage broker that I did not want to escrow and he told me that when it’s sold on the open market that they sell for a lightly lower rate. All the places I checked with that do allow you to opt out of escrows were asking a 0.25% one time fee.