Alternative to a 15-Year Mortgage: Prepay on a 30
By Jeff Brown
The average rate on a 15-year mortgage offers a pretty significant savings over the 30-year loan. But payments are much larger on 15-year deals because the debt must be paid off twice as fast. Many borrowers just don�t want to commit to that, or can�t afford to.
Fortunately, you can have it both ways � by making extra principal payments on a 30-year mortgage. That way you can pay the loan off early, saving a fortune in interest. Because the interest rate is higher on the 30-year loan, the savings aren�t quite as good as you�d get on a 15-year deal. But that�s offset by flexibility. You could make extra principal payments only when you wanted to, while you�d be stuck with big payments if you got a 15-year loan.
The trick is to make an apples-to-apples comparison that accurately looks at the costs of the two loans.
At the current average rate of 4.709%, according to the BankingMyWay.com Tracker, a $300,000 loan for 15 years would cost $2,327 a month, and interest would total $118,888 over the loan�s life.
At the average of 5.269%, a 30-year loan for the same amount would cost $1,660 a month, with interest totaling $297,653 over three decades. (Use the Mortgage Loan Calculator to try your own numbers and see the effect of prepayments.)
The savings on the 15-year deal are awfully appealing, but paying $667 more a month is not.
The alternative? Take out the 30-year loan and plan to make extra principal payments as often as possible. If you paid an extra $667 every month, ending up with the same payment you�d have with the 15-year deal, interest would come to $143,415 over the life of the loan, and it would take about 16 years to pay off the debt.
That�s a significant savings � $154,239 less interest than if you�d made minimum payments on the 30-year loan.
On the other hand, you�d pay $24,527 more than if you�d taken out the 15-year loan, because the interest rate would be a tad higher on the 30-year deal.
For many borrowers, that�s a reasonable price for the right to pay just $1,660 a month instead of $2,327.
But there�s another benefit to the 30-year-with-prepay approach: it makes cash available for other investments, which could be valuable if market conditions improve.
Extra principal payments are a form of investment that produces a �return� in the form of interest savings. Your rate of return equals the interest rate on the loan, since each prepayment saves you that interest charge.
On the 15-year loan, you earn 4.709% by shouldering those higher payments, while extra principal payments on the 30-year deal would earn 5.269%.
Since these returns are guaranteed, they are comparable to earnings on fixed-income investments like certificates of deposit or U.S. Treasuries. Either mortgage currently offers better returns than you can find with safe fixed-income investments.
But that could change. If 10-year Treasuries started paying 6% or 7%, instead of the current rate of 3.8%, you could stop making extra principal payments on the 30-year loan and put the money into Treasuries instead. You wouldn�t have that option if you were locked into higher payments on a 15-year loan.
Of course, you could also divert that prepayment money to riskier investments like stocks in hopes of even bigger gains. That could easily offset the $24,527 penalty you�d pay by accepting the slightly higher interest rate on the 30-year loan instead of the 15-year deal. And you�d have peace of mind from knowing you�d have flexibility whenever money was tight.
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