15 vs. 30-year
mortgages
[an error occurred while processing this directive]When you buy a home in the U.S. you get a
mortgage loan
that's paid back over 15 or 30 years.
If you can afford it, you should generally take the 15-year note,
because you'll pay off your house in half the time, and save a ton of
interest.
But most people take a 30-year loan. That's
because:
- 30-year loans are more affordable, because the monthly
payment is lower.
- You can qualify for a bigger loan (i.e., a more expensive
house) than with a 15-year loan.
- Sometimes a 30 is all you can get. (You might not qualify
for a 15-year loan.)
Let's take a look at the difference with a calculator. Feel
free to enter in
your own numbers for your own situation.
 If a 30-year is all you qualify for, then you don't
have to worry about choosing between the two, since there's no choice
to make. You take the 30 because that's all you can get. But if you can
qualify for either, which should you pick?
In most cases if you have a choice, you
should take the 15. You'll save a bundle of interest and
pay off the loan in half the time.
Note that even if you take the 30, you can still make
prepayments to pay it off in 15 years, and save interest just as if
you had a real 15-year loan. An advantage of doing it this way is that
you keep your monthly payments low so that if money gets tight, you're
not locked into a higher monthly payment. With a 15-year loan you have
to make the higher payment every month whether you want to or not. With
a 30-year loan whether you make extra payments each month is up to you.
So a 30-year loan gives you some extra flexibility. Of course, if
you're not diligent about making extra payments on a 30-year loan, then
you'll pay more interest
Taking a 30 and investing the
difference
A possible advantage of a 30-year mortgage is that
since the payments are lower, you can take the money you're saving each
month from the lower payments and invest it in something else.
That
keeps your investment liquid, so if you run into hard times you can
easily turn your investment into cash. If you'd taken a 15-year
mortgage your investment would be locked up in your house, and it
wouldn't be easy for you to turn that equity into cash.
The reason I say this is only a possible advantage is
that it requires you to be diligent in investing the difference between
the payments each month. And unless you get a great return on your
outside investments, you'll wind up with less money. That's why most
people should just get a 15 and not worry about all this. You should
invest the difference to keep your capital liquid only if:
- You're diligent about investing the difference each month,
and
- You're either getting a great return on your outside
investments, or you're willing to sacrifice some return in order to
keep your capital liquid.
Let's see how this works. Let's say your payment would be
$1100/mo. on a 30-year loan vs. $1500/mo. on a 15-year loan. Instead of
taking the 15-year loan for $1500/mo., you take the 30-year loan for
$1100/mo., and invest $400/mo. separately somewhere else (mutual funds,
high-yield CD's, socially-responsible stocks,
etc.).
By doing this your investment remains liquid. Your
house is an investment, sure, but you can't eat your house. Any money
you put into your house is money you can't easily get back out. The
only way to monetize that investment is to sell the house or borrow
against it (refinance or home equity loan). And if times get tough
(like you lose your job), then ironically no bank will let you
borrow against your home because they're worried that a jobless person
won't be able to pay them back. By contrast, if you invest your cash in
mutual funds or other similar investments, it's always easy to sell
them to access your cash.
How much you sacrifice for this flexibility depends on what
kind of return you can get on your other investments. In a scenario
I'll run below on a $150k home at 5.75% interest, investing your extra
cash elsewhere at 5.25% means you'll pay an extra $143k over the life
of the loan, vs. getting a 15-year loan.
Now we'll see why this "investing the difference" idea isn't
the goldmine some seem to think it is.
Why "investing the difference"
doesn't work
Some writers feel so strongly you should take the 30 that
they
so far as to say that 15-year mortgages are a "sucker's bet"!
Dan Green says that by investing the difference in
payments, you not only keep your cash liquid but you wind up making moremoney
because you get a bigger tax break on the higher interest. Some
readers asked me to comment on this, so here's my take.
Mr. Green is dead wrong. He appears to have made
not just one, but several mistakes in his analysis.
- Green is counting only the tax benefit and not the
expense penalty. He says, "Because
mortgage interest is tax-advantaged, we will want to keep the interest
as high as possible for as long as we owe money on the house."
This is wrong,
because the cost of the interest is way more than the benefit
of the tax
break. Trying to keep your interest payment high is like spending
a
dollar to save a quarter.
- Green assumes that every dollar of mortgage interest
is deductible, but that's usually not the case. The IRS lets
you "itemize"
all your deductions on Schedule A, or you can just take a blanket $5000
deduction. Let's say you itemize $7,000 in mortgage interest and
$2500
in other deductions, for a total of $9,500 in deductions. If you
didn't
itemize you'd still get the $5,000 standard deduction. So the extra
deduction you get from itemizing is only $4,500 ($9,500 -
$5,000). So
the mortgage interest deduction reduces your taxable income by only
$4,500, not the full $7,000 of mortgage interest you paid.
- He assumes you're in a whopping 33% (!) tax bracket.
Most Americans aren't rich and pay a much lower percentage of their
income in taxes. [Note: Green updated his page to use a 28%
bracket, but this is still higher than most Americans pay.]
- He assumes you'll invest your annual tax savings
religously.
This is wishful thinking. I can imagine maybe 1 in 1000 people
actually
being dedicated enough to follow that plan.
- He's not considering that the money in your outside
investments is taxable. If you make 5.25% from your
investments,
but you're in a 25% tax bracket, your effective return is only
3.94%.
That dramatically reduces the amount of return you make from
compounding.
- Finally, I'm not sure he's considering that with a
15-year
loan, it's paid off in year 16, and then you can start investing
the money you're not spending on mortgage payments into something
else.
I can't tell for sure whether he's omitting this because the images on
his page don't load.
Put all this together, and we see that 15-year mortgages
easily beat 30-year notes. Here's an example for a $150,000
loan.
15-year
|
30-year
|
|
| ($74,158) |
($176,920)
|
Mortgage interest
|
|
$106,310
|
|
Income from taking the $1245/mo. that we no longer have
to pay the bank,
and investing it elsewhere for years 16-30
|
|
$162,947
|
Income from taking the 30-year loan and investing the
difference
between 15- and 30-year payments, over 30 years
|
$5,898
|
$13,891
|
Tax benefit from mortgage interest deduction
|
|
+$38,050
|
-$82
|
Net gain (loss) on investment
|
Assumptions: 5.5% rate on the 15-year loan, 6%
rate on the 30-year
loan,
7.1% rate on outside investments, or 5.33% after tax in the 25% bracket
Now, if you get a great rate on your outside
investments -- like more than 7% -- then taking a 30 and religiously
investing the difference could be a better bet than taking a 15.
But you're unlikely to enjoy a return greater than 7% consistently for
30 years.
At more realistic rates of return, here's why a 30-year
can't beat a 15:
- You pay more than twice as much interest with a
30. In our example, you pay $174k vs. $74k.
- 15-year note takers can invest too.
Those with 15-year notes get to invest a whopping amount of money in
years 16-30, when they no longer have a mortgage payment to make.
- The tax advantages on a 30-year mortgage are tiny.
They don't come close to making a 30-year note more attractive than a
15 -- even if you're in a high 33% tax bracket.
So with a 15-year loan you usually come out way ahead.
You save
a ton of interest, which in most cases will dwarf your outside
investments.
Fifteen-year mortgages are for suckers? I don't think so!
Please do note that even though the 30-year note is usually
more
expensive overall, it does let you have easy access to your capital, if
that's important to you. It's just that in exchange for that
flexibility you'll usually pay a lot of extra interest in the long haul.
By the way, here's my Google Spreadsheet which has a little more detail
about the numbers in the table. I'm sorry, I couldn't figure out
a way to get Google to let you play around with the numbers,
without your having the ability to save and permanently change the
spreadsheet.
Related topics:
Last Update: June 2011
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