I’ve heard a lot of talk lately about paying off your mortgage. In order to do so earlier, some people talk about taking out a 15-year mortgage instead of the more traditional 30-year mortgage. By using a 15-year mortgage your home is paid off 15 years sooner (obviously) as well as you pay less interest and usually at a lower interest rate. Sounds like a good deal right? So if you have the cash flow a 15-year mortgage is the way to go, right? Wrong. Well maybe let’s leave it at it depends for now and here’s why.
Let’s say you have a $300,000 mortgage. I looked up the rates on bankrate.com. I found that current 30-year mortgage rates are 5.16% and 15-year mortgage rates are 4.67%. Using these rates the monthly payments are $1,639.93 for the 30-year and $2,321.13 for the 15-year. This leaves a difference of $681.20.
Scenario A
You take out a 30-year mortgage for $300,000 at 5.16% with a monthly payment of $1639.93 and save an extra $681.20 per month. This savings over 30 years (360 months) grows to $684, 276 with a 6% rate of return.
Scenario B
You take out a 15-year mortgage for $300,000 at 4.67% with a monthly payment of $2321.13. Once you pay the mortgage off you continue to save $2321.13 per month for the subsequent 15 years. This savings would grow to $675,028 with a 6% rate of return.
I would say that scenario A beats scenario B. If not just for having an extra $9,000+, how about for having more liquidity if something were to happen. Or maybe because of paying more interest you would actually have more tax deductions and would technically pay less taxes over the 30 years. How about that?
Okay well let’s be fair what happens with different returns. I mean it is the power of compounding that gives scenario A the edge. The money there is compounded over a longer period of time. Well at 8%, scenario A: $1,015,233 and scenario B: $803,200. I guess that helps make my point. Let’s go the opposite direction with a return of 5%, scenario A: $566,935 and scenario B: $620,412.
Conclusion
For those of you with or thinking of a 30-year mortgage, I think this might just make you feel better about it. It can work better for you by providing more tax deductions, more liquidity and with solid returns you will be in a better financial position in the end.
For those of you thinking about a 15-year mortgage, can you get a 6% rate of return or better? That’s a big question.
Yes, I’ve probably oversimplified this a bit but hopefully it makes you think. That’s the point right?
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{ 12 comments… read them below or add one }
I couldn’t agree, more. Clearly, the difference is close, either way, BUT the big difference lies in the additional liquidity that you discuss. IF you lose your job, AND you have a fifteen year fixed mortgage, the bank will NOT let you refinance into a 30 year fixed with a lower monthly payment, because without a job, you will not be qualified for that new mortgage. On the other hand, if you had the thirty year fixed, and set aside that extra money that you’re not paying, monthly, on your mortgage payment, you have a nice reserve of cash into which you can dip while you are securing your next job.
This is one case where, I feel, being less fiscally conservative (by not choosing to try and pay off your home sooner than later) can actually be the safer choice. For me, it’s about what allows me to sleep better at night.
John Scott Smith
@JohnScottSmith
You’ve gotta love that compounding interest although in my experience most people don’t have the discipline to save the extra money each month.
May I suggest a hybrid solution? Get a 30-year mortgage, have the difference between the 15-year and 30-year payment automatically transferred to savings each month and make an additional principal payment at the first of each year.
From one math nerd to another-enjoy!
http://ctrlyourcash.wordpress.com/2009/06/24/phrenology-astrology-global-warming/
Betty
all good things
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I found this information very interesting and I am looking forward to more posts!
Hi Evo, noted your comment to me on @bostongal. I went to 15 from 30 (w/extra cap each mo.). Thanks. I haven’t run #’s, but have 2 points to offer:
1. My note is for $155k. 30 was @5.875%, 15 is at 4.375%. Not sure how that skews the analysis, esp. the amount. The delta is diminished, so I suppose the 15 looks better, but need to think about it.
2. The decision to stay 30 is also when considering driving up savings #’s. We have enough cash to pay off note completely, so I feel the worry over the payment delta if something bad happens is lessened quite a bit.
I’d love to hear your thoughts.
crispy
30 year fixed usually will free up money to invest in a Roth IRA and 401k. If you aren’t maxing out both retirement vehicles then you are losing the tax break usually 15-25% at least which is much more than the 6% interest.
Plus with retirement accounts if you don’t max it out, you can never go back. The interest saved on taxes from a 401k more than pays for the difference. Use the 15 and 30 year difference to max out a 401k.
We might be able to afford a 15 year fixed if we didn’t max out my DH’s 401k.
You make some great points and thank you for the comment. One thing I purposely didn’t mention is where to put the “savings”. Too many people think you just invest it, unfortunately I can’t necessarily recommend that. This is money that you are going to need and investing it can be risky. The problem with a 401k is liquidity. A key to using the 30 year mortgage is to have increased liquidity in case life happens.
Don’t get me wrong maxing out a 401k can be great when done properly. It shouldn’t be your first goal though.
You also didn’t mention inflation as another reason to go with a longer term loan. My true interest rate of our house is 3.26% (with tax deductions) visit this site for the calculation
http://www.bankrate.com/calculators/mortgages/loan-tax-deduction-calculator.aspx
Inflation over the past 30 years also happens to be 3.26%, so it’s almost an interest free loan.
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Thank you John. It’s good to know that a post does what you want it to do. I completely agree with you and appreciate your comments. Thank you for reading.
EW
@EvolutionWealth
Betty:
It’s true that most people don’t have the disclipline. The idea for this post is targetted at the people who are considering a 15-year mortgage. I’m guessing they might have more discipline when it comes to saving the difference because they can afford to. Then as I wrote this I thought it was a great way to get people thinking outside the box. I want to open people up to different and better ways to do thing. Thank you for reading and your great comments.
E of W
@crispy If you want to talk more about your specific situation feel free to e-mail me at: evolutionofwealth@rocketmail.com. I definitely have more questions for you if you would like some real answers. First off the spread between the 15 and 30 year rates is too big. Second, if you are seriously weighing the option it becomes important how you save the difference in payments.
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