This debate can be perfectly summarized by two radio personalities/podcasters I listen to: Dave Ramsey vs. Ric Edelman. I like both of them in different ways but on the question of what kind of mortgage to get they are polar opposites. Ramsey permits the idea of a mortgage – the only kind of debt he does – but encourages his listeners to pay off their mortgages quickly after starting to save for retirement. Edelman thinks that people should carry the largest mortgage (on a reasonably priced house) possible and keep refinancing into 30-year mortgages forever to maximize cash flow. Of course, there are advocates in the PF blogosphere for both of these approaches.
Let’s put the 15-year and 30-year mortgages head-to-head to directly compare them in terms of the net worth outcome after 30 years.
Scenario: A homeowner has the ability to take out either a 15-year or 30-year mortgage on the same property. The home value is $256,900 and she puts 20% down; the interest rate on the 15-year mortgage is 2.91% and on the 30-year mortgage is 3.62% (1). The homeowner is in the 25% tax bracket. The monthly payment on the 15-year mortgage is $1,410.40 and the payment on the 30-year mortgage is $936.70. If the homeowner goes for the 30-year mortgage, she will invest the difference between that payment and the payment for the 15-year mortgage. We will disregard inflation because it affects both scenarios proportionately.
First, let’s consider the account balance at the end of 15 and 30 years of the investment account, assuming that it is growing tax-free (in a Roth IRA, for instance) at a rate of 8%. In the first 15 years, the 15-year mortgage homeowner doesn’t make any investments (related to this scenario) but in the last 15 years she is able to invest the entire amount of the previous mortgage payment (2).
Second, we need to take into account the mortgage interest deduction. I’m not a fan of this deduction and I hope it disappears, but for now it is in place and it affects each scenario differently because the 30-year mortgage holder pays more interest. The interest deduction is also invested monthly with a return of 8% (3).
Third, we need to adjust for the fact that there is still a mortgage on the property at the end of 15 years for the 30-year mortgage.
The clear advantage is to the 30-year mortgage and the difference at the end of 15 years of these two different strategies is $53,184.72 and at the end of 30 years it is $303,313.60. That is pretty startling! And check out the time value of money! So why would anyone advocate for the 15-year mortgage over the 30-year?
1) The Assumptions Could Be Wrong
I believe the only assumption in the above scenario numbers-wise that could tip the advantage to the 15-year mortgage is the difference between the loan interest rate and the possible return elsewhere. If you have debt at a fixed interest rate that is a known quantity – if you pay it down (faster), your return is that interest rate. The return you can get elsewhere, for instance in the stock market or in a business, may be higher but it is also more uncertain and unstable.
The interest rate and investment return environment right now is pretty unique and crazy. You can get a mortgage for 3%-ish (if you have great credit) but the stock market has returned 12% over the last year. That is a striking difference and favors the 30-year mortgage coming out way ahead. But in another environment, the mortgage interest may be comparable with or even higher than the possible return elsewhere, depending on the time horizon, and then the advantage will tip to the 15-year mortgage. (Personally I am a long-term investor and don’t try to time the market, so I would prefer the historically higher average return of the market and therefore the 30-year mortgage, given these low interest rates for borrowing.)
Here is the outcome of the same scenario, run with 6% and 10% returns as well as 8%.
You can see that the lower the rate of return the smaller the difference between the two outcomes becomes and the higher the rate of return the more the 30-year mortgage scenario benefits. When the rate of return dips below the 30-year mortgage interest rate, the favor starts to tip to the 15-year mortgage, as you would expect (though the time value of money still benefits the 30-year mortgage).
The mortgage interest rate is the certain part of the equation and the rate of return elsewhere is the uncertain part. I can imagine that at times it would be difficult to tell which would be the better return. However 1) interest rates are so low right now that it’s a pretty low bar for other investments to beat and 2) the historical average in the market, for instance, is higher than most interest rates most of the time.
2) People Don’t Behave Optimally
Some things could happen to the homeowner that would render the above numbers less helpful for making the decision between the 15-year and 30-year mortgages:
- Her income could change. Income decreasing is what we would be more concerned about. The 30-year mortgage provides more flexibility since she is not locked in to the higher payment and could forgo the additional investing for a time. But that just means that the she owns too much house so that’s not good.
- Her tax bracket could change. Going to a higher tax bracket will make the mortgage interest deduction a larger component of the investment and favor the 30-year mortgage (assuming she can still afford to invest the payment difference). Vice versa as well.
- She could lose the mortgage interest tax deduction if she chooses not to itemize or that loophole is closed, the tax deduction disappears as well as the investments (sort of – she could always invest a portion of her standard deduction if that still exists), favoring the 15-year mortgage.
- The homeowner could choose to move before paying off the mortgage. Selling the house wouldn’t affect the overall balance between the mortgages but just may encourage short-term thinking and these huge numbers are really due to the time value of money. She would also have to not touch the invested money for her next down payment or closing costs or whatnot.
- Her money might not grow tax-free. If the homeowner doesn’t have room available in tax-advantaged retirement accounts like a Roth IRA or a 401(k) the returns from the investments will be dampened and the 30-year mortgage has less of an advantage.
- She may choose to remove money from her investment account or decide to save less monthly. That applies for possibly cash-out mortgage refinancing as well but I think it’s a bigger danger for the 30-year mortgage.
The homeowner could have some personal characteristics that could render the above numbers less relevant.
- She could be debt-averse like DR and some of his followers. That’s just a philosophical thing so if she doesn’t want to be in debt or the interest paid bothers her all the money she could (potentially) make in the market doesn’t matter.
- She could be risk-averse and wouldn’t be able to generate better returns with her investments than she could get by paying off her mortgage faster.
- She might not have the intestinal fortitude to stay in the market through downturns (i.e. she must have the mindset of a long-term investor). She has to resist the temptation to buy high and sell low.
Let’s Get Real
What are the chances that anyone actually does this – buys a house with a mortgage that she can afford to pay off in 15 years but chooses to extend it for 30 years (or even longer) and invest the difference? That takes a lot of self-discipline. Taking out the 15-year mortgage or paying it off even faster is definitely a better use of money than taking out a 30-year mortgage and wasting the difference in payments. For many people it would be better to make the one-time decision to pay a higher monthly mortgage payment than to have to re-decide every month or every year to keep up the aggressive investment schedule. Plus, don’t most people buy a house with a payment they can barely afford on a 30-year mortgage, hoping for future raises and such?
Part of the reason I wrote this post was to settle for myself which of these two approaches is more beneficial. I think that Kyle and I would have the self-control to invest the payment difference between the 30-year and 15-year mortgages (and perhaps also the tax deduction). However, I’m not sure that we will be able to buy a house we can afford a 15-year mortgage on since we are planning to buy in southern CA. If we did start the investment strategy with the 30-year mortgage and then our income decreased (for instance if I stopped working for a while) we might be derailed from our plan. So I guess we will have to make a decision on the ground when we have a house picked out and we know our incomes a little better, but I’m glad to have laid out the advantages of each choice in this way since the PF gurus don’t really encourage balanced discussions.
Is there anything else this analysis should take into consideration? If you have ever taken out a mortgage, did you compare different mortgage lengths and how did you choose? Are you paying off your mortgage early (minimizing interest) or taking as long as possible (maximizing cash flow)? If you don’t yet have a mortgage, which camp do you think you’ll be in?
(1) source: JW’s post on 15 and 30 year mortgages
(2) I used an amortization schedule spreadsheet as a starting point and did all of my calculations off its provided interest payments and the difference between the monthly payments.
(3) I’ve set up the math so that the deduction for the interest paid each month is invested each month, which is doubtful to play out exactly in practice since the homeowner would probably make the calculation for each year instead of each month, but I think the end values will be close, especially if the homeowner invests the tax savings monthly by increasing her take-home pay instead of upon receiving a tax return.
photo from Free Digital Photos