Many home buyers and real estate investors wonder whether they should go with a 15-year or 30-year mortgage term.
Different financial experts will advocate for different loans—and they’ll be right for different scenarios, too. What’s the difference between them—beyond the fact that one lasts for 15 years and the other for 30?
Real estate financing: Key definitions
Before we continue, let’s get into four key definitions that might clarify your decision-making.
What is amortization?
Amortization is the reduction of debt over a specific time period.
When it comes to fixed-rate real estate mortgages, a mortgage payment will include the interest payment and the principal payment, which is what directly reduces the amount of the loan down.
Usually, the initial years of the loan will have higher interest payments and lower principal payment. During the later years of the loan, the opposite applies.
What is PITI (principal, interest, taxes, and insurance)?
Most times, mortgages come with an escrow account set up by the lender, which allows the lender to pay your property taxes and insurance premiums on your behalf. The addition of these components make up the acronym PITI:
This is valuable when considering the different interest rates and tax deductions of each mortgage option.
What does net operating income mean?
For the real estate investor, net operating income (NOI) is guided by a simple formula:
NOI = revenue from a property (i.e., rental income) – operating expenses
Examples of operating expenses include vacancy reserve, management fees, utilities, and rental licenses.
What is cash flow after financing?
Cash flow after financing is a little different than your standard cash flow, which simply calculate your net proceeds each month.
This metric takes financing expenses into account. In this case, because we are considering two financing options—a 30- and a 15-year mortgage—it is important to consider your cash flow after financing as opposed to before. That will help you understand the true bottom-line benefit of each option.
Cash flow after financing = Net operating income (NOI) – CapEx reserves – financing costs
CapEx—or capital expenditures—is where you budget for big-ticket system breakage—like replacing a roof or HVAC system. All investors should calculate this for their properties before buying.
But regular homebuyers should pay attention to CapEx, too. It will help you understand how much you need to keep in your savings. After purchasing a home, you should set cash aside for repairs or replacements, depending on the condition of the house.
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The key advantages of a 15-year mortgage
A 15-year mortgage might be a great choice for you depending on your goals, and here’s why.
1. Pay it off faster
The time it takes to pay a 15-year mortgage off is significantly shorter, but it comes with a higher monthly payment.
However, for some buyers, a short loan-life could hold advantages beyond simply paying the mortgage off faster.
2. Build equity faster
With a higher monthly payment, your money is building more equity in the home and paying off more of the principal.
3. Fewer fees
Since 15-year mortgages are paid off quicker than 30-year mortgage loans, the banks consider these loans less risky to approve.
From the lender’s perspective, less risk means fewer fees to collect.
4. Lower interest rates
Because 15-year mortgages are less risky, banks set lower interest rates for their short loan life compared to 30-year mortgages.
Advantages to a 30-year mortgage
Low-risk leveraging might be your friend, whether you are a first time homebuyer or a long-term investor. Although 15-year mortgages are less risky for banks, 30-year mortgages are less risky for homebuyers.
1. Lower monthly payments
With a longer loan period comes lower monthly payments, since the loan amount is spread out over more time.
2. Higher tax deductions
Mortgage interest payment tax deductions are higher for a 30-year mortgage due to the higher interest paid. While this isn’t a major advantage, it is definitely something to consider when doing an analysis.
3. More monthly income available for other savings goals
Whether you are investing or aim to save more cash, a 30-year mortgage increases the amount of money available to help you reach these goals each month. Your monthly mortgage payment will be considerably lower for a 30-year mortgage, as your loan is amortized over a longer period compared to a 15-year mortgage.
So what’s better—a 15- or 30-year mortgage?
Both loan options have advantages, but how do you know which one is the best choice for you?
Know your goals
What are your goals for the property? And how does that fit into your overall goals for your life or for retirement?
For an investment property, are you wanting more income and cash flow to save more for your children’s college? A 30-year mortgage might be for you. Or would you rather build equity fast for your personal residence, so you can avoid paying a mortgage during your retirement? You may want a 15-year mortgage.
Plus, it’s a good idea to consider what payment you may or may not be able to afford in the future.
Staying aware of possible life changes goes a long way regarding your finances and investment decisions.
For example, you can send a higher monthly payment for a 30-year mortgage. But you can’t send in the lower payment for a 15-year mortgage. That’s where flexibility comes into play.
Also, if, heaven forbid, something bad were to happen—such as job loss, a family issue, or a health problem—could you ensure that you and your family would still be able to afford the higher monthly payment? This is an important consideration, as are other ways to insure your investments or your nest egg (i.e. disability and life insurance).
But what if your goal is still to pay off the property sooner and save on interest?
Pay extra, if you wish
While you may not be able to get it down to exactly 15 years by making additional payments on a 30-year mortgage, you could still knock years off of the life of the loan.
For example, let’s say you were to sign up for biweekly mortgage payments. You would essentially be making 13 monthly payments—or 26 biweekly payments—instead of 12. That extra payment would go towards the principal of the loan, reducing both the loan balance and the amount interest charged over the life of loan.
Mortgages & Creative Financing
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.