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30 or 15 year mortgage?

Chris Farrell Aug 12, 2009

Question: Hi, I am a 34-year-old single woman with no debt, a comfortable, stable salary, and a high saving rate. I am planning to buy a home for the first time and need to get a mortgage. I can put 20% down for the down payment but the question is, what length of mortgage should I sign up for? My bank is advising me to get a 30-year mortgage (about 35% of my income) but my parents are pushing for a shorter-term mortgage (20 or even 15-year) with the argument that I would build equity in the home much faster. In their opinion, the total interest you pay over the course of the loan only benefits the bank — not the owner. What is your opinion on this? Laura, Hanover, NH

Answer: Your parents are right. The 15-year fixed-rate mortgage does save you a lot in interest payments. For example, a $100,000 mortgage at 6.25% for 30 years will cost you $121,900 in interest if your marginal tax rate is 25%. The interest charge on a 15-year mortgage at 6% is $51,900. (The rate on a 15-year mortgage is lower than the 30-year rate.) So, it’s a good move if you have the cash flow to absorb the higher monthly mortgage tab. The main advantage to you of the 30-year mortgage is that your monthly outlay is significantly less.

However, there is another option: The 13th monthly payment. Many people like locking in the lower monthly payment of the 30-year fixed-rate mortgage, but they don’t want to pay the bank all that interest. They make an extra monthly payment during the year. You just tell the lender to apply the 13th payment to paying down principal. You cut your interest payments significantly this way. For instance, by making one more monthly payment on a 30 year fixed rate mortgage at 6.25% you’ll shorten the life of the loan by 5 years 4 months, saving $27, 263 in interest.

The advantage of this approach is flexibility. Let’s say your financial circumstances change–you lose your job, you need a new car, your children need extra tutoring–you can always go back to the 30-year payment schedule with no penalty. Just make sure there is no prepayment penalty with the mortgage if you go this route.

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