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15-Year vs. 30-Year Mortgages: A Comparison
Buying a home can be an intimidating process. Mortgages are fairly complicated, and there are a variety of different types to choose from. The most common debate revolves around the 15-year versus the 30-year fixed-rate mortgage. With interest rates near all-time lows, there have been many recent articles outlining different sides of this debate. One in particular that caught my attention was this article from Time quoting financial experts about why a 15-year mortgage can potentially make more sense than a 30-year mortgage.
Let me preface this by saying every situation is going to be different, and that the following considerations are based on the current interest rate environment. Let’s look at the arguments made and examine why the psychological component of a 15-year mortgage may be advantageous to some, but the mathematical evidence shows us otherwise. (For related reading, see:What Is the True Cost of Owning a Home? )
Argument 1 for a 15-year mortgage: Save More Money
“Taking out a 15-year mortgage dramatically cuts your home-loan repayment time. The faster you repay the loan, the less in interest you need to pay. This can save you tens of thousands of dollars over the (shorter) life of your loan. A 15-year mortgage also usually offers better interest rates than other loan products," says Debbie Todd, a CPA.
Why we disagree…
The problem with this is that interest rates are now hovering right around the range of inflation (around 4% or lower). Assuming you would invest in the stock market with the excess money you’d be saving on monthly payments by acquiring a 30-year mortgage rather than a 15-year mortgage, and assuming recent average historical returns, your money can do far better for you in that manner. Let's take a look at an example of Jordan and Matt, each of whom wants to get a $400,000 mortgage. For this example, we will make it simple by assuming there is no down payment on the house.
Matt is paying $996.15 less than Jordan per month. Let’s say that Matt invests that full amount in the stock market each month which historically has returned 8% annually depending on the time period you look at (we will also look at it with a more conservative 6% and 4% rate of return). With these assumptions, Matt’s investment account will be worth:
Not convinced by these numbers? Try out a free online compound interest calculator. So now let’s add that amount to the equity Matt has in his house after five, 10 and 15 years and compare it to Jordan's investment.
** Using 8% annual rate of return. See chart above for other rates of return such as 4% and 6%.
As you can see, as time goes on, the difference only gets greater. By the time Jordan has paid off his house in full, Matt will have accumulated $193,451.13 more equity that Jordan. Of course, if interest rates go up substantially, this analysis changes, but given the current market, it looks like Matt’s course is the wiser one.
Argument 2 for a 15-Year Mortgage: Build More Equity
“When you repay your mortgage faster, you don’t just save money — you build equity in your home faster too. Combine a shorter mortgage term with rising home prices, and you could exponentially grow the amount of equity you have."
"This is beneficial for several reasons, especially if you want to refinance the loan down the road. “Since you are paying principal faster with a 15-year note,” explains Therese R. Nicklas, CFP, “you will be building equity faster, making refinancing potentially easier.” With a smaller loan-to-value ratio, the risk you present to your lender will be smaller, so you should have more financial opportunities."
The argument here is that by repaying the loan faster, you not only save money on the lifespan of the loan, you also build equity in the home faster.
Why we disagree…
The problem with this is that a home is not an investment, in the truest sense of the term. We say that because of the carrying costs that come with purchasing a home. Most investments don’t require ongoing investments. Between your mortgage, taxes, insurance, utilities and general maintenance, these ongoing expenses will at a minimum partially offset the amount of market value the house could theoretically gain over the course of your ownership. (For more, see: The Benefits of a Mortgage in a Low Rate Environment .)
We constantly preach the importance of diversification. For the vast majority of first time home buyers, the home is far and away their most valuable asset. By accelerating your mortgage, in this scenario, you are putting an enormous percentage of your net worth into one asset, which is contrary to the notion of prudent diversification. Even worse? Your home is not a liquid asset. It’s not like investing in other assets such as the stock market, where if a crisis occurred you would be able to sell your investment and get the funds. You can’t just sell a house overnight.
Even if there is a time period of deflation, that doesn’t change the point that once your cash goes into a house, it is much harder to get out. In this type of scenario, you could always prepay your
To further explain this point, let’s look at how it would all play out after 30 years if Jordan decided to start investing the full amount of his mortgage payment after he finishes paying off his house in 15 years. At the same time, Matt will continue his monthly contribution for the remaining 15 years of his mortgage.
That’s a difference of $528,750.10 over a 30 year period. To show you that this works even at 4%, here's the comparison with that rate of growth:
Argument 3 for a 15-year mortgage: Reduce Pressure on Your Monthly Budget in Retirement
“Getting a 15-year mortgage might help if you plan to retire in the next 10 to 20 years. Many people want to downsize before they retire, and that means buying a new home. “Choosing a 15-year mortgage allows you to reduce the strain on your cash flow in retirement,” says Eric Roberge, a financial planner."
“You can take advantage of stronger cash flow while you’re working to make the bigger monthly payments that a 15-year mortgage requires and pay off the loan before you retire,” Roberge says. “Then, when you do retire, you won’t have to pull as much out of your savings to cover living expenses since your loan will be gone.”
Why we disagree…
While we agree with the general concept here, we want to make sure people understand there are other costs associated with owning a home than just the mortgage. There is no doubt a physiological advantage to reducing the pressure on your budget in retirement but as we aim to point out, the math doesn’t always support that in full. (For related reading, see When Consider Paying Off Your Mortgage.)
You still have to pay for taxes, insurance, upkeep and repairs. Another issue we have is that we are neither factoring in inflation nor the other expenses that come with owning a home. Expenses such as insurance and taxes will continue to increase with inflation. At the same time, as I allude to above, when you factor in inflation, your housing payment actually gets cheaper each year in real dollars.
Argument 4 for a 15-year Mortgage: Take Advantage of Built-in Discipline
"Instead of considering 15-year mortgages, some people take out a 30-year mortgage and simply accelerate the payments they make on that loan. They get the benefit of saving money on interest but aren’t tied to the higher monthly payment. But Todd Tresidder, a money coach, explains that while this sounds good, the situation isn’t always so simple. “If your intention is to pay off the mortgage in 15 years, then commit to it,” he says. “You may prefer the flexibility of a lower mortgage payment by getting a 30-year loan, and you may honestly have the best intentions to add principal to pay it off in 15 years anyway.”
"However, many people just don’t follow through with that plan. It’s too easy to fall back on making the smaller, easier payment and using the extra payment money for other purchases instead. “Without the enforced discipline of the required payment, it won’t happen,” says Tresidder. “So just be honest with yourself.”
Why we disagree…
If you don’t have the discipline to pay off your monthly expenses then you should rethink whether it makes sense to buy real property at this time. If, on the other hand, you are confident that you can hold yourself accountable to paying off your monthly expenses, why not afford yourself more flexibility? You can always pay off a 30-year fixed mortgage in 15 years, but you can’t do the reverse. (For related reading, see Got a Raise? Here’s How to Avoid Lifestyle Creep )
In summary, we agree that doing something for psychological reasons — as well as to achieve a sense of security and fiscal prudence — has merit. Having said that, by understanding the interest rate market and the pros and cons of home mortgage schedules, you may rethink the psychology of the idea that 15-year mortgages are wiser than 30-year mortgages. It pays to recognize that there are additional factors that may turn this debate in another direction.
The views expressed in this blog post are as of the date of the posting, and are subject to change based on market and other conditions. This blog contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Please note that nothing in this blog post should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and you should not consider anything to be, investment, accounting, tax or legal advice. If you would like investment, accounting, tax or legal advice, you should consult with your own financial advisors, accountants, or attorneys regarding your individual circumstances and needs. No advice may be rendered by Sherman Wealth unless a client service agreement is in place.
Category: Mortgage interest