A mortgage is a long-term commitment that carries some hefty penalties if breached. However, borrowers can control how long they wish to be locked into a mortgage.
The typical mortgage terms are 15-year and 30-year. Now most will instinctively opt for a 15-year as it’s shorter. However, it’s important to properly understand the implications of each loan term, in the context of your personal circumstances.
What are the key differences between a 15-year and 30-year?
There are no material differences in the underlying characteristics of a 15-year compared to a 30-year. Both loans create a debt obligation, are subject to periodic interest payments, and may carry penalties.
The interest rate is lower on a 15-year compared to 30-year mortgage, and the reason is due to the time value of money. An independent lender takes on greater risk over a longer period, due to fluctuations in interest rates over that period. To account for this risk, lenders charge a higher interest rate. However from a nominal perspective, the monthly payments of a 30-year are lower than a 15-year.
What does the maths tell us?
Let’s assume a mortgage of $500,000, which is the average mortgage amount in Australia. The 15-year interest rate is 2.50%, whereas the 30-year interest rate is 3.00%. Let us also assume that there are no hidden fees or penalties over the life of each loan.
The side-by-side comparison of the loan terms is as follows:
| 15-Year | 30-Year | |
| Mortgage Amount | 500,000 | 500,000 |
| Interest Rate | 2.50% | 3.00% |
| Monthly Interest Payments | 3,333.95 | 2,108.02 |
| Total Interest Paid | 100,110.29 | 258,887.26 |
There are some notable differences between the two loan terms. For starters, the monthly interest payments on a 30-year are considerably less than the 15-year. However, the lower monthly payment is offset by the fact that you pay approximately 1.5x the interest under a 15-year loan.
Why some prefer the 30-year loan term
Despite the larger interest sum, many individuals and families would still opt for a 30-year loan term. This can be explained by the fact that most of the population is on a fixed income.
The median pre-tax Australian salary is $90,000, which is approximately $68,000 post-tax. This roughly equates to $5,700 per month as a take-home pay. Therefore, a lower monthly interest payment may be more a necessity than a choice.
Alternatively, some homeowners may choose to allocate their disposable income to other life pleasures. For instance, a recent survey conducted by Jetstar suggested that 90% of Australians surveyed plan to travel in 2021. Therefore, higher monthly mortgage repayments will certainly dampen some Australians’ wanderlust.
There is also a clear opportunity cost with a higher monthly repayment. By paying more on your mortgage, you lose the chance to invest that money in a higher rate instrument. The smaller monthly repayments provides you greater flexibility to capitalise on potential gains in the equity market, or other investment opportunities.
Why the 15-year loan term may be popular among homeowners
As mentioned, a monthly payment under a 15-year loan can be quite steep. You may have to say goodbye to any fun activities for some time, particularly in the early years.
However, there is a significant upside.
Per the example above, you will save over $150,000 in interest. That’s a year and a half salary for the average Australian. In terms of real estate, that equates to 1-2 down payments. Alternatively, you would need $5 million invested in the market to receive $150,000 in returns (assuming a 3% rate of return).
So in summary, this is a sizeable saving when choosing a 15-year over a 30-year. While you may feel the pinch on the mortgage payments, know that it should be temporary, as you will continue to advance in your job and thereby increase your earning potential.
Which loan term wins out?
If I were starting out my real estate career today, and I was looking to purchase my first home, I would likely go for a 30-year mortgage. While I’m confident in my selling ability and work ethic, I lack a stable monthly income.
However, if I were to choose a profession with a stable income stream, I would certainly consider a 15-year mortgage. The early years would be tough, but the sacrifices will go a long way to building my portfolio in the later years.
The content outlined above was written, edited and published by the Lost Realtor. The author has over 20 years or real estate sales and investing experience in the Australian property market. He has held senior positions in Australian building companies, including being the General Manager of the residential sales division of Collier Homes. His qualifications include a Bachelor of Commerce degree and a Graduate Diploma in Building and Construction Law.