Mortgages undoubtedly constitute the biggest component of the total cost of owning a home. A mortgage is nothing more than a loan you take out to buy a home. A mortgage allows you to purchase a $150,000 home even though you yourself have far less money than that to put towards the purchase. With few exceptions, mortgage loans in the U.S. are typically repaid over a 15- or 30-year time span. Almost all mortgages require monthly payments.
How a mortgage works
Suppose that you are purchasing a $150,000 home and that you have diligently saved a 20 percent ($30,000 in this example) down payment. Thus, you are in the market for a $120,000 mortgage loan.
You sit down with a mortgage lender who asks you to complete a volume of paperwork. There are literally hundreds of mortgage permutations and options.
Imagine, for a moment, a simple world where the mortgage lender offers you only two mortgage options: a 15-year fixed-rate mortgage and a 30-year fixed-rate mortgage (fixed-rate simply means that the interest rate on the loan stays fixed and level over the life of the loan). Here's what your monthly payment would be under each mortgage option:
- $120,000, 15-year mortgage @ 7.00 percent = $1,079 per month
- $120,000, 30-year mortgage @ 7.25 percent = $ 819 per month
The interest rate is typically a little bit lower on a 15-year mortgage versus a 30-year mortgage because shorter-term loans are a little less risky for lenders. Note how much higher the monthly payment is on the 15-year mortgage than it is on the 30-year mortgage. Your payments must be higher for the 15-year mortgage because you're paying off the same size loan 15 years faster.
Total cost of a loan
But don't let the higher monthly payments on the 15-year loan cause you to forget that, at the end of 15 years, your mortgage payments disappear; whereas, with the 30-year mortgage, you still have 15 more years worth of monthly payments to go. So, although you do have a higher required monthly payment with the 15-year mortgage, check out the difference in the total payments and interest on the two mortgage options:
- A 15-year mortgage equals $194,147 in total payments and $74,147 in total interest
- A 30-year mortgage equals $294,700 in total payments and $174,700 in total interest
It shouldn't come as a great surprise that (with a decent-sized mortgage loan like this one) you end up paying more additional interest. The 30-year loan is not necessarily inferior, for example, if its lower payments better allow you to accomplish other important financial goals, such as saving in a tax-deductible retirement account.