If you’re like most people these days, purchasing a home means getting a mortgage. A 30 year mortgage is very common but did you know you have other choices as well? Have you considered a 15 year mortgage? You would pay off your loan in half the time of a 30 year and the savings on interest would be huge. That’s obviously a great thing right. But is that really the best option for YOU?
To answer this question, I spoke with my friend Whitney Emanual who is a financial planner with Eagle Strategies. To preface the discussion, let’s lay a foundation.
Breaking down the numbers
If you purchase a home for $250,000, with a down-payment of 20% that would leave you with a $200,000 mortgage. Assuming an interest rate of 4% and a 30 year amortization (i.e. the time the loan will be paid in full if all payments are made as scheduled), you would have a monthly payment of $954.83. This example does not include taxes and insurance as that will vary by property and location. Over those 30 years you would have paid $143,739.01 in interest. Does that number make you want to throw up or what?
Now assume the same numbers as above, but this time let’s change the amortization to 15 years. This directly changes your monthly payment by increasing it to $1,479.38. It also reduces your total interest cost to $66,287.65. You should be able to spot the huge benefit here! As mentioned earlier, you’ve just paid off the same loan in half the time and saved $77,451.36 on interest. The choice is obvious – isn’t it?
In reality, your decision shouldn’t be made just on the amount you’ll spend on interest. The difference of the monthly payment between the 15 year and 30 year mortgage is huge - $524.55 to be exact. For some reading this, that amount of money on a monthly basis is no big thing. But to others that’s their monthly grocery bill. And that’s where it’s important to consider your monthly budget.
Your Monthly Budget
While it’s not the focus of this post, it’s important to take a moment and consider your budget. Whether you work a salaried, commission, or hourly job, you should be able to gauge an expected income amount. You should then be able to plan out your routine expenses such as food, fuel, entertainment and of course housing! It might shock you to hear this, but you’re supposed to set your total expenses amount to be less than your total income amount. Who would have thought?
If you’re new to home ownership, two things you may not have thought to put in your budget are repairs and improvements. As a renter you didn’t really have to worry about the unexpected, like your hot water heater going out, or the routine, like the annual furnace tune-up or even your dreams of getting new kitchen cabinets. As a home-owner, that’s all on you. If you don’t start planning for them now, you’ll be blindsided by the inevitable. So be sure to add in as much as you can on this budget line item and consider opening a separate bank account with an automatic transfer.
Do you know what’s going to happen in your life 20 years from now? What about near year?
Once you know your budget, you’ll be able to see if you can afford that extra $524.55 each month. But let’s take this a step further. Planning your monthly housing payment for the next 15 to 30 years is difficult. In the ideal world you will have steady increases in your pay over that time and won’t have any trouble making your payments. But the reality is that the future is uncertain. You never know when there will be a change in your industry, your health, or your family that could reduce your income or increase your expenses making it difficult to make your payments. I assume you know what happens if you don’t make your payments, right?
Consider the best of both worlds.
Turns out financial planning takes into consideration both avoiding extra interest payments AND conservative thinking. Of course everyone needs to make their own decision considering their own circumstances and seeking out their own financial counsel. But one option that Whitney likes to discuss with her clients is going for the 30 year mortgage while adding extra payments towards the principal whenever possible.
For example if you consistently add $100.00 to your monthly payment, you would pay off your 30 year mortgage 5 years early, and would save $26,855 of interest costs. Then if you ever ran into a financial hardship you could revert to the regular payment without effecting your credit score or risking the loss of your house to foreclosure. You could even contribute more to your principal if you get an unexpected bonus from work or a generous gift for Christmas.
Whatever you decide, make sure you consider how your monthly housing expense fits into your immediate future as well as the long-term future. And lastly, when you go to make that $250,000 home purchase, be sure to work with an experienced real estate agent like John Stiles.
Many thanks to Whitney Emanual for taking the time to share about this important topic. If you would like to discuss your specific financial situation with Whitney, please email her at WEmanuel@newyorklife.com or call 612-296-6939.