In this article, I recommend that a 30-year fixed-rate mortgage is best for most people. I realize this may be controversial among the finance blog/FIRE community, but I think I have a solid case to make. I have come up with four criteria that a home-buyer should consider when choosing between a 15 vs 30-year mortgage, and readers of this blog will disproportionally meet them, but some won’t. In any case, this post is targeted at the typical high-income professional working a normal-length career, not a FIRE hobbyist saving 60% of her gross income and wanting to retire by 45.
The key advantage of a 30-year mortgage is the lower monthly payments. For example, consider the purchase of a $1M house with 20% down and an $800,000 mortgage. For a 30 year mortgage with a 4.0% interest rate, the monthly principal and interest (P&I) payment would be $3,819. The main reason to consider a 15-year note over a 30 year is that the interest rate is typically lower. At today’s rates, the difference is about 0.25%. For a 15 year mortgage at 3.75%, where the monthly P&I would be $5,817; it means a difference of $1,998. For most people, the advantage of a lower payment outweighs the lower interest rate.
4 Criteria for Deciding Between a 15- or 30-Year Mortgage
#1 The Payment
For those buying an inexpensive house relative to their income, the higher payments for the 15-year note are less of a burden, so the lower interest rate might be worth it. Here in Southern California, where home prices and taxes are both high, and physician incomes are low, this is a rare situation. Between the coastal states, it’s much more common.
Keep Debt-to-Income Ratio Less Than 30%
Banks considering you for a mortgage typically look at your “debt-to-income ratio” (DTI), which is the ratio of your monthly payment on the mortgage (including principal, interest, property tax, and insurance), plus any monthly payments on other debt you may have (car loans, credit cards, etc.), divided by your gross monthly income. Most banks will not write you a mortgage with a DTI of more than 43%, but just because a bank will lend you that much money doesn’t mean it’s a good idea for you.
Even in a high cost-of-living area, I would recommend keeping your DTI less than about 30%. More than that, and you lose too much financial flexibility by having to make those huge fixed monthly payments. But if you can get a 15-year note on your house purchase with a DTI of less than 30%, it might be worth considering.
#2 Contributing to Tax-Advantaged Accounts
Can You Make the Payment AND Max Out Retirement Accounts?
The tax savings of contributing to tax-advantaged accounts is too good to pass up for a 0.25% savings on a mortgage rate. If, however, you can comfortably make the payments on the 15-year note AND make the maximum contributions to all your available tax-advantaged accounts, then the 15-year note might be worth considering.
The contribution limits on tax-advantaged accounts might be higher than you think. If you and your spouse are at least 50 years old and your spouse works too, you could have easy access to $108,000 of annual contributions to tax-advantaged accounts: $56,000 plus $6,000 catch-up to your individual 401k, $19,000 plus $6,000 catch-up to your spouse’s 401k, $6,000 plus $1,000 catch-up Backdoor Roth IRA contributions for each of you, and $7,000 for the family Health Savings Account. Even if your age doesn’t allow you to make catch-up contributions now, you still need to account for them if you or your spouse will turn 50 during the term of the loan.
You might have access to more or less than this amount. Make sure you are able to comfortably contribute the annual maximum to all your available retirement accounts, as well as your other savings goals (eg. education), with some positive cash flow left over, before choosing a 15-year mortgage.
#3 Investing vs. Paying Off Debt
A fundamental issue at the heart of the 15 vs. 30-year mortgage question is whether the money saved with the smaller payments can earn a better return elsewhere. Mathematically, the “return” of paying down debt is equal to the after-tax interest rate. This can be compared to the after-tax rate of the return from various investments.
Historically, stocks have returned about 10% per year and bonds have returned about 5%, although current yields on investment-grade bonds are closer to 4%. For a younger investor with decades to grow a nest egg and some tolerance for taking risk, a portfolio tilted toward stocks (say, 80% stocks and 20% bonds) is usually recommended by financial planners. It wouldn’t make sense for such an investor to earn an 8% return (after-tax if the investments are inside a tax-advantaged account) and simultaneously pay down a 3.75% mortgage (about 2.5% after-tax, if interest is tax-deductible) on an accelerated schedule. After 15 years, the $1,998 per month payment difference invested to earn 8% will exceed the remaining balance on the 30-year mortgage with lots of money left over.
Even under the worst conditions, if mortgage interest is not tax-deductible, investing in a taxable account, and with California tax rates, you would only need to earn a 5.7% annual return on a side investment to outperform the interest rate difference between the 15 and 30-year notes. Over a time period more than a decade, this return should be achievable with reasonable investments. If you’ve already decided you can handle the volatility and risk of more aggressive investments, you might as well take advantage of the higher returns with the smaller payments on the 30-year note.
On the other hand, with a conservative portfolio returning closer to 5% with still some risk, it makes a lot more sense to take the guaranteed “return” of around 2.5-4% by paying off the mortgage faster with a 15-year note, especially if mortgage interest is not tax-deductible.
Finally, anyone considering a 15-year mortgage should have a very stable income. If family income drops or is eliminated for some time, the lower payments on the 30-year note will make it easier to bridge that gap without defaulting. Fortunately, the majority of those reading this post (physicians) likely have unusually stable jobs already. If you have a spouse who works in another field and contributes to your household income, you need to consider their job stability as well.
Who Is a 15-Year Mortgage Right For?
In summary, if you are buying an inexpensive house relative your income, can easily fully contribute to your tax-advantaged accounts, prefer conservative investments, and have an especially stable job, a 15-year mortgage is probably the right choice. Everyone else should get a 30-year mortgage, at least until the current interest rate environment changes.
You should lean toward a 15-year mortgage only if all of the following apply to you:
- Payments on the 15-year note will not be a burdensome percentage of your income.
- You are able to maximally contribute to all of your available tax-advantaged accounts (401(k), IRAs for self and spouse, HSA, etc.) while making payments on the 15-year note.
- You tend to invest in conservative lower-return assets (like bonds) much more than riskier higher-return assets (like stocks).
- Your income is very stable.
Other Factors Affecting Your Decision
Another advantage of the 30-year mortgage, although harder to quantify, is that it provides more protection against inflation. In the case of high inflation, those fixed monthly payments will become easier and easier to make.
Along with this protection comes a higher level of liquidity by having (presumably) larger liquid savings. If your situation changes, it’s easy to decide to pay off the mortgage faster, or completely. But, if you need to go the other direction later and liquidate some of your home equity, it will almost certainly be at a higher interest rate than a mortgage you can get today.
I know many readers of this blog are debt-averse, and I understand why, but there are some real advantages to carrying debt on as good terms (long term, low interest, tax-deductible, no call risk) as a 30-year mortgage.
Pay Off Strategies
Some Bogleheads and bloggers recommend taking a 30-year mortgage but paying off on a 15-year schedule. Of course, this strategy loses the benefit of the lower interest rate, but it does pay off the loan just as fast while giving the flexibility to drop to a smaller payment if your cash flow situation requires it. Personally, I don’t like this strategy.
On the example loan I gave above, it costs $100 extra per month to pay the higher interest of the 30-year mortgage on a 15-year payoff schedule, and this difference might or might not be tax-deductible. If I had the means and were committed to paying off the mortgage in 15 years, I would want the benefit of the lower interest rate. Put another way, would I buy an insurance policy from the mortgage company with a $100/month premium that let me decrease my payments by about one third any time I wanted? Probably not. But if you decide it’s worth the money to you, go ahead.
One argument in favor of the 15-year mortgage I don’t accept is that the higher payments represent “forced savings” by building home equity, and this is better than spending the difference in payments on frivolous things. This point is where the behavioral and mathematical aspects of personal finance intersect.
It’s definitely true that a 15-year mortgage is a better option than a 30-year mortgage if the monthly difference is wasted by meaningless spending. However, if you or your spouse have a behavioral finance issue, you really need to fix that issue before buying a very expensive house and the decades of large payments that come along with it. Once the behavioral issues are fixed, then you will be in a position to make the mathematically best choice. In any case, most savings and investment accounts can be set up with automatic contributions anyway, so the temptation to spend money in the checking account can be just as easily removed this way as with a 15-year mortgage.
What do you think? Did you choose a 15 or 30-year mortgage when you bought a home? Do you agree with the recommendations of the author that most should choose a 30-year mortgage? Why or why not? Comment below!
[Editor's Note: Chris Davin is an aerospace engineer at NASA Jet Propulsion Lab (The opinions and viewpoints expressed in this article are the author's and not NASA JPL) and the spouse of an EM physician. While looking for a house to buy in Southern California, he began to carefully consider the issue of choosing a 15 vs 30-year mortgage. After a lot of research, he decided to write a guest post and share his findings with our community. We have no financial relationship.]