NEW YORK (MainStreet) — As we previously reported, the gap between 15- and 30-year mortgage rates is especially high these days, offering huge interest savings to homeowners who can shoulder the higher monthly payments on the 15-year deal.
Of course, many homeowners can’t afford those bigger payments brought about by the need to pay the principal off twice as fast, and many borrowers who can afford the bigger payments may be reluctant to commit to them, fearing some financial setback during the next decade and a half.
It may pay to split the difference by taking out a 30-year loan and making extra principal payments to pay the loan off early, thereby reducing interest charges. With this approach, your loan rate wouldn’t be quite as low as with the 15-year deal, but you could still save a fortune and not be required to make the extra-large payment if you didn’t want to.
Let's look at the pros and cons of this approach.
Assume you can get a loan at today’s average rate, which is 4.34% on a 15-year loan and 5% on a 30-year, an unusually large difference.
If you borrowed $300,000, the 15-year loan would cost $2,271 a month and interest would total $108,695 during the loan’s life, according to the Mortgage Loan Calculator.
With the 30-year loan for the same amount, you’d pay $1,610 a month, but interest would come to a whopping $279,770 over 30 years, since you’d pay interest for twice as long.
Now let's look at the third option. You take out the same 30-year loan but add $661 to your payment every month to reduce the principal. The payment would be the same as with the 15-year loan -- $2,271 – and the loan would be paid off in about 17 years, bringing your total interest charges to $136,586.
That’s $27,891 more than you’d pay with the 15-year loan, as a result of the higher loan rate, but it would be $143,184 less than if you made only the required payments on the 30-year loan.
Sure, the 15-year deal is cheaper overall, but by paying about $28,000 extra with the 30-year-prepay option, you’d preserve the ability to make the lower payment if your finances become a bit tight. Of course, every time you did make the minimum payment, you’d be lengthening the time it would take to pay off the loan, adding some interest costs to the eventual total.