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Right Ways to Mortgage: Fifteen Years, Please!

It’s as traditionally American as baseball and apple pie: When you buy a home in this country, you take out a 30-year mortgage to do it. These mortgages are so common that almost everyone just assumes that it’s what they’re supposed to do. There’s just one problem — that 30-year mortgage is costing you tons of unnecessary money.

In this series, we’re investing the best ways to use mortgages to buy our family homes. While consumer debt is dangerous, mortgages  for home purchases come with a lot of characteristics that protect us. But if we don’t handle mortgages correctly, they can be just as costly as credit cards or car loans. As we’ve already learned, mortgages work best when you have a large down payment, and when you borrow at a fixed interest rate. And they’re most beneficial to you if you use 15-year loans.

What’s so bad about 30 year mortgages? You pay a ton of money in interest that you don’t really need to. Taking a 15-year mortgage instead can save you tens of thousands of dollars.

At first blush, a 15-year mortgage might seem more expensive than a 30-year mortgage. After all, if you have to pay $100,000 in half the time of a traditional 30-year mortgage, it seems like your payment is going to be twice as much. But that’s not the case at all. In most cases, your payment on a 15-year mortgage is going to be only a bit more than on a 30-year mortgage. And in the end, you will have payed the bank much, much less money.

How does this work? It all has to do with interest rates. Mortgage lenders set the rates of interests that we pay on their loans, and they set lower rates for shorter-term loans. If their money is going to be tied up for a long time, that creates a lot of risk for them, and so they charge a premium interest rate. Cut that amount of time from 30 years to 15 years, though, and you’ve significantly lowered their risk. They, in return lower their interest rates.

As of this writing, Wells Fargo Home Mortgage is offering 30-year loans at a fixed annual percentage rate (APR) of 3.799%. On the other hand, 15-year mortgages are going for 3.182% APR. While this seems like a minuscule difference, remember that half a percentage point on a very large loan amounts to thousands of dollars of difference each year. Since you pay less interest each year, your monthly payment on a 15-year loan is much less than twice the amount of a 30-year mortgage payment. And since you’re only paying for 15 years, you pay much, much less money in interest, and you’re out of mortgage debt much earlier in life.

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Let’s look at an example and see how this all plays out. Assume that you’re borrowing $100,000 (to buy a $125,000 house). Here’s how the mortgage would look  in both scenarios:

30-year loan (3.799%): You pay $465 per month for 360 months. At the end of the loan, you will have payed $167,724 which includes more than $67,000 in interest.

15-year loan (3.182%): You pay $699 per month for 360 months. At the end of the loan, you will have payed $125,886 which includes more than $25,886 in interest.

In this scenario, the 15-year loan raised your payment, but only by $234 per month. But look how much money it saved you — instead of paying more than $67,000 in interest, you paid only $25,886. That’s a savings of more than $41,000.

When we talk about mortgages and buying homes, we tend only to think about the purchase price of the home. But we have to remember that the true cost of the home is not just the purchase price — it’s the purchase price plus all of the interest that you pay over the years. On a 15-year loan, this $125,000 house really costs us $150,886. On a 30-year loan, it cost us $192,724.

My question is this: The value of the home is the same, whether you buy on 15-year terms or 30-year terms. So why would you pay $41,000 more for the same home?

Let’s put it another way: If you can get a pizza for $5, why would you pay $6.38 for it? If you could by a car for $10,000, why would you pay $12,772 for it? If you could go to college for $40,000, why would you pay $51,091 for the same degree from the same university?

You wouldn’t. So why do we routinely overpay on interest for our home loans? In part, it’s because that’s what we’ve always been taught to do. But many of us also do it because we’re stretching to buy the biggest, nicest houses that we possibly can. For many people, the couple hundred dollars each month that they “save” in lower payments allows them to buy the house that they really want. What they don’t realize is how many thousands of dollars that “savings” is going to cost them in the long run.

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If you want to really mortgage with wisdom, use this rule: Only buy a house that you can afford on a 15-year mortgage. Don’t even consider a 30-year loan. These long-term mortgages are much more costly, and they trap you in debt for the majority of your life. True, with a 15-year mortgage you may not be able to buy a place that’s quite as big or quite as nice. But at the end of the day, you will have saved a ton of money.

What’s more, 15-year mortgages free us from house payments much sooner. Take out a 15-year mortgage, and you’ll own your home free and clear by the time you’re 50 years old. Once you’re not making a house payment, you’ll have a lot of monthly cash left over for investing, giving, paying for your kids to go to college, or simply having a good time. Over time, that extra money can add up to hundreds of thousands of dollars.

With some wisdom, some bravery and a few basic math skills, we can buck the American mortgage tradition and set our financial futures free. I hope you’ll join me in making this great financial decision.

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Photo by Victor1558. Used under Creative Commons License.

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