Coffee, tea or milk? As consumers, we select from hundreds of brands of computers, cars, airlines, mortgages and more. Even after we pick a product such as a fixed rate mortgage, there are even more considerations with regard to the mortgage term. The choice of term may affect our long term economic plan and influence our retirement strategies.

The difference between 30-year and 15-year fixed rate mortgages, easily the most popular consumer alternatives, are quite clear. The 30-year allows the lowest payment and achieves the greatest tax advantage because a larger portion of the mortgage is dedicated towards interest. The 15-year requires a larger payment, a greater portion of which is dedicated towards principal reduction and achieving the goal of rapid equity accumulation.

Let’s view the differences in the payment breakdown of the choices ($100,000 mortgage/7.5% interest rate)–

Note that this example does not take into consideration the disparity in rates between these mortgages. Fifteen year mortgages are typically available for somewhere between one-quarter of one percent to one-half of one percent below 30-year alternatives.

The above example represents the first month of a mortgage’s amortization schedule. An amortization schedule breaks out the principal and interest payment for each month and adds the balance after that month’s payment is affected. Note that the interest paid will drop every month for both mortgages because some level of principal is retired each month. The reduction in interest will be much more accelerated for the 15-year mortgage because of the increased rate of principal reduction.

Which option is more attractive for which type of mortgage consumer? If the higher 15-year payment is not affordable, then the choice is obvious. Let us assume in our analysis that the consumer can afford and qualify for each level of payment.

A consumer who is expecting to stay in the home for a longer stretch will typically come out ahead with a 15-year. Over the life of the mortgage, the consumer will pay approximately $85,000 less in interest in the above example. Even with the effects of tax deductibility taken into consideration, the difference is quite significant.

The 20 year mortgage story. Is the 15-year the most attractive way to build equity in your home through larger monthly payments? To answer this question, we add another column to our previous alternatives:

What is the significance of viewing the 15-year and 20-year mortgages as compared to a 30-year mortgage? It shows us that the increased payment is relatively small for a 20-year: $106 monthly is roughly 46% of the total increase required for the 15-year mortgage ($228 monthly).

This amount is considered relatively small when compared to the benefit gained for a 20-year mortgage. The 20-year mortgage achieves 66% of the benefit when measured against the 15-year’s result of shortening the term of the 30-year. Ten years is two-thirds of the difference between a 15-year and 30-year.

In other words, you receive two-thirds of the benefit for less than 40% of the cost! Why is this so? When prepaying a mortgage, there is a point of diminishing returns that kicks in around the 20-year term. This is illustrated by viewing the payment necessary to retire a mortgage in 10 years:

*it takes $228 monthly to achieve 15 years of payoff. The extra five years costs another $260 monthly.

The bottom line? There are many economic scenarios in which a shorter mortgage term would benefit a mortgage consumer, however the efficiency of shorter terms varies from one term to another. For many, a 20-year mortgage would be an affordable alternative, balancing lower monthly payments with accelerated equity build-up for retirement.