Why 15 Year Mortgages Have Lower Rates than 30 Year Mortgages

One might think that interest rates should be the same on all kinds of mortgages. A 15-year mortgage should have the same rates as a 30-year mortgage. However, this is not the case.

Rates are tied to Risk

Interest rates are a function of risk. This means that higher risk loans get higher interest rates while low risk loans get lower interest rates. Naturally, a loan made for 15 years is less risky than a loan made for 30 years, here’s why:

1. Inflation. Inflation is the rise in prices over time. Said another way, inflation is the rate at which $1 today will lose spending power in the future. It is much more difficult to predict the rate of inflation over 30 years than it is to predict inflation over 15 years.
2. Default risk. When you borrow for 30 years, you agree to make your mortgage payments on time for 360 months. That is a long time in the future, and anything can happen in the next 30 years. However, a 15 year term is much more predictable for banks, and thus the interest rate is lower.
3. Capital favors shorter periods. Ask yourself, would you invest in something that might not pay off for 30 years? Most investors have short term investing horizons, meaning that there is more money out there willing and able to finance 15 year loans than there is money waiting for 30-year long opportunities. Borrowing works on the basis of supply and demand. There is more demand for 30-year loans and yet a much smaller amount of money willing to supply 30-year loans.

Is the rate all that matters?

The interest rate is not the only important detail on a loan. An interest rate does affect the amount of interest you pay over the long haul, but the term of the loan also influences the following:

• The size of your monthly payments.
• The affordability of your home.
• The comfort in your payment size.

While it may be foolish to borrow for 30 years if you can afford a 15 year mortgage, it is equally foolish to buy a home on a 15 year term if you will find it difficult to make the monthly payments. Also, in this low rate environment, it may make sense to lock in the lowest mortgage rates we have ever seen for the very long haul.

Many people defer paying off their mortgages by selecting a 30 year mortgage and investing the difference between a 30 and 15 year mortgage payment in their retirement accounts. Will that bet pay off? Only time can tell!