I participated in a discussion over at the Get Rich Slowly forums about mortgages today. Strangely enough there was a lot of talk in my office about refinancing mortgages because of the Fed rate cut. (Even though rate cuts don’t necessarily guarantee lower mortgage rates.) I try to be the voice of reason in my office, which can get pretty frustrating with all of the random financial ignorance that gets thrown out.
But anyways, let’s talk about mortgages. To start, at no point will I ever support anything other than a fixed, regular mortgage. None of the adjustable rate mortgage (ARM), option-ARM, or interest-only crap. Get a fixed mortgage, get a fixed payment, and pay it on time. Simple enough.
The only question that remains then is payback period. The 30-year fixed rate mortgage is the standard in the industry. Your parents likely had one, and their parents before them. The close cousin to the 30-year fixed is a 15-year fixed rate mortgage. Your payments are higher, but you are paying more principle back with each payment than a 30-year fixed payment. You save interest (slightly lower interest rate and shorter term) and cut your time with the mortgage in half.
Running the math: 30-year fixed versus 15-year fixed
I’ll use data that is current as of yesterday evening. Bankrate publishes national averages for various types of mortgage rates. As of yesterday a 30-year fixed comes in at 5.53%, a 15-year fixed comes in at 5.26%.
With both mortgages we will assume:
- $250,000 home value
- $50,000 down payment (20%)
- $200,000 mortgage (80%)
- all other costs identical (closing, fees, etc.)
Now let’s run the math on the monthly payment.
Note: I made a typo in my original calculations when this was posted in December 2008. The old, incorrect values have lines through them and the correct numbers are added directly to the right. Updated April 2009.
- 30-year: $1,339.35 — $1,139.35
- 15-year: $1,608.81
Difference in payments? $269.46 — $469.46
What if you pay the 30-year fixed like it was a 15-year fixed?
If you get the 30-year fixed and apply the pay the additional $269.46 $469.46 each month that you would have spent on the 15-year (and do it consistently, every single month) you shave off 10 years and 9 months 14 years and 6 months on the loan. That brings the total length down to a little more than 19 years 15 years (actually 15 years and 6 months).
This may seem to point toward getting the 15-year fixed. You’re saving more than 4 years worth of payments (and additional interest) by locking your payment in for 15 years.
(This now heavily favors my original opinion of getting the 30-year mortgage and paying it like a 15-year mortgage. You pay it off in nearly the same amount of time while getting payment flexibility. Granted, if you don’t add the extra into every payment your payoff date will be expanded out further than calculated.)
But I disagree. While you will save money with the 15-year mortgage, I prefer the flexibility of a 30-year mortgage. The lower payment builds in a tad bit more of a buffer for your finances in case you lose your job or some other emergency comes up. You can choose to add to your payment each month if you are able to — act like it’s a 15-year mortgage. But if something comes up that’s a little bit less stress on the budget. You aren’t forced to make that higher payment every month.
Let me finish by saying if you can afford a 15-year fixed… then by all means, do it! The above advice is for the people that would be over-extending themselves by going the 15-year route.
To all of you with mortgages, what are you in? ARM? 30-year? 15-year? I’m curious to see how many are on the 15 versus the 30-year. Leave comments!
***UPDATE:*** An awesome reader informed me of a serious typo in my calculations.
Originally I had the 30-year mortgage payment at $1,339.35. That is incorrect. The correct payment is $1,139.35. The difference in payments is $469.46.
That’s a $200 difference and it makes a huge difference in the payoff of the 30-year loan is significant.
I re-ran the calculations and if you applied the difference in the 30-year and 15-year mortgage to the 30-year loan, the payoff is 15 years and 6 months. You end up losing 6 months worth of payments, not 4 years and 3 months as I originally calculated.
This further confirms my belief that the 30-year (if you are disciplined) is the better option. The savings between the two is nearly $500 and could make a significant difference in your budget if you got into a pinch. Yes, paying off the loan faster with a 15-year mortgage would be great. But a well disciplined payoff of a 30-year mortgage will work almost as well.
(And isn’t it amazing what a difference $200 makes!)
Another point this makes: don’t trust everything you read. Don’t trust my numbers. Trust your own. Do your own math. Call me out on mistakes.
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Kevin, are you trying to provoke me this morning? 🙂
While a 30 year does give you significantly more flexibility and better cash flow, it does so at a HUGE cost. Look at the total amounts paid over the life of the mortgage for both the scenarios you’ve described and you’ll see just how much extra this flexibility costs you- by my estimations, an extra 4 years of $1,600 per month payments = ~$77,000.
If you’re concerned about flexibility, there are a number of steps to help- first, make sure you’ve got a well funded emergency fund to fall back on so that you can continue to make payments even if things go bad. If you run into trouble with your 30 year, dropping back your payments still only saves you $270 per month. If things are that tight, its unlikely that this is going to be of much benefit.
If you really need that extra flexibility, a better option is probably to buy less house to keep the payments at a lower level.
I have both types of mortgages, as I signed up for an 80/10/10 mortgage package. This means that 80% of the purchase price is in the form of a 30-year fixed rate mortgage (at 5.875%) and 10% of the purchase price is a 15-year fixed rate mortgage (at 8.0%). Naturally, I want to kick the 15 year mortgage to the curb early. Starting next July, I’ll be putting an extra $200 toward the second mortgage. My goal is to pay it off by 2014. That will save us about $7,000 in interest.
@MGL: True, it could be costly… but then again how many people keep a home 15-20 years? I’ve heard that most people usually live in a house for about 10 years before moving on. If you really wanted to pay it off in 15 years you could adjust your extra payments to help knock it out.
@Fit: Thanks for the feedback. We got an 80/15 with the 15 also being a 30 year fixed. The loan officer tried to pitch me on an interest-only for the 2nd mortgage and I said no thanks.
I haven’t looked at this in a while, but last time I did, the spread between rates for 15 year and 30 year mortgages were even closer. At one point, they were even identical.
In that case, it clearly makes no sense to get a 15. In general, I would only do a 15 if the difference in rate was enough to make it worth it — and I would peg that at half a point, minimum, but that is an individual decision.
Yep, they tried to sell us on a balloon payment for the second mortgage. I said NO THANKS! I’d rather build equity than worry about what happens when the full 10% is due in 15 years…
We’re two years into a 30-year fixed mortgage. We put down 20% and financed the rest of the purchase price, which was under $300k. Right now we are able to almost double our monthly payment. Our payment is ~$1450, and we pay an additional $1250 on top of that, automatically, every month. Some months, when we can manage it, our additional principle payment is larger. I desperately want to be out from under this mortgage, our only debt.
I would like to refinance to secure a lower interest rate, but each time I look into it, the numbers just aren’t there. I’ve been told that given our ability to pay extra each month, we should just stay the course with our 6.375% rate. Given all the fees associated with refinancing, I suspect this advice is pretty sound.
@Kate: I would definitely check around. Mortgage companies are desperate these days. I would imagine you could swing a deal with very little closing costs. I would check with a credit union as well — they generally are going to have lower fees.
I am going to have to disagree with you on this one. When it comes to debt, a shorter term is always better. If you are concerned about having more flexibility, bolster your emergency fund. Even if you only make one payment on your mortgage and then sell your house, you still have more equity with a 15 year term than you would with a 30 year term. I have a 30 year fixed for my first mortgage and a 10 year fixed for my second, but if I could afford the payments on a 15 year fixed I would do it in a heartbeat.
We have had our house for a year and a half. We have a 30 year fixed at 6.625% but are in the process of refinancing to 5.75% also a 30 year fixed. I feel so much safer having a fixed rate and am very thankful that our mortage advisor found us a good, safe and secure deal.
I can’t believe nobody has tried to throw up the loss in interest that you claim on your tax return by paying it on the 15 year? How would anyone take this into account?
Anyway, mine is a traditional 30 year with 5% down. Through a credit union and got a better rate that way.
Philip,
Spending a dollar to save a quarter is terrible math.. I hate that argument.
Great post, and we’ve already seen in the comments, quite controversial. I’ve had both 15 and 30 year mortgages at different times in my life. I think that you have to take a hard look at your own situation, throw in a little wiggle room, then plan from there. Obviously, a 15 year mortgage saves money. Heck, a 0 year mortgage would save a LOT of money. We own two homes (one is a rental) that both currently have 30 year mortgages. At one point, we had refinanced the rental to a 15 year mortgage, but we would have had great difficulty buying our present home with the higher payment required on the 15 year loan – not that we couldn’t afford the extra couple of hundred dollars a month, but it was enough to push our debt-to-income ratio out of whack for purposes of obtaining a new loan. One thing that I’ve noticed in calculating refinances is that I always say, “Oh, we’ll have this house(loan) forever and then while we have kept the house, we’ve refinanced again after just a few years (one time it was a few months!) Of course, I can’t see the rates going much lower than they are now. We’ve still come out ahead with the refis, but sometimes it was pretty darn close.
Thanks for a timely and thoughful post.
The rates HAVE gone a lot lower since 2008. As of now, I have two options: 15 years at 3.00% or 30 years at 3.75%. It looks like we will have our 403(b) and IRA fully funded even with the 15-year option. Does it make any sense for us to get the 30-year loan?
There are some big IFs that I’d consider.
The idea of being mortgage free in 15 years is more than compelling.
It sounds like the 15 will let you still fund retirement, and that’s the biggest concern.
On the flip side, if you are 100% disciplined, and take the difference in payment, there’s a very high chance you will see a higher return with low cost indexing. Note – the 15 years ending 2011, which included 2 bad crashes, returned a CAGR of 5.43%. If the next 15 years returns a decent 8-12%, you’ll be thrilled, a horrible 0-1%, and you’d be a bit behind and not so happy.
I’m not pushing either route. The one factor I believe most will agree is tops – the sleep factor. If the 15 year lets you sleep better, do it. If 5 years into the 30 the market crashes and you’d lose sleep over the losses, it’s not for you. In the crash of ’08, for the full year, my net worth was down by 4 times our gross income, I slept like a baby. It took until 2011 to get back to that level.
Rates won’t go any lower huh? 😉
We’ve had both a 15y and now a 30y (purchased two months ago). For the previous house we decided on a 15y w/20% down because we planned to stay in the home for at least 20y. Even though we ended up accepting a job promotion/transfer after just 5 years it still paid off nicely for us – we had lots of equity when we sold 3 months ago + we were lucky in that the home value nearly doubled. We decided on the 30y w/20% down for our new home because we were doubling the amount of the loan but still wanted payments close to what we were making on the old home – we pay just $71 more per month and don’t plan to move again for about 15 years, when the kids are gone and we retire. Right now the extra $ we would have put towards a 15y is being invested to pay cash for our retirement home – it seems wiser to go this route than to hope that the equity and value of this home will be enough to outright buy our final retirement house.
@Ricky: There’s the kicker … “if I could afford the payments on a 15 year fixed I would do it in a heartbeat.” Not many can, which makes the 30 an attractive option. I said at the bottom of the post that if you can afford a 15, then by all means do it. As Kate mentioned, a 0 year mortgage would be best, but is also highly unrealistic for 99% of us.
@Philip: It might be difficult to run the calculations on the interest deductions of the longer mortgage. That’s why I didn’t do it 🙂 You’ve got to take into account that you’ve got to hit the limit (something around $10k?) to itemize first.
@Kate: Good point about the debt to income ratio.
Plus, the 30-year for us allows us to invest money in the market and begin to build up our portfolio. Is it better to pay off the house? In an ideal world, yes, but I don’t want 100% of our wealth tied up in a home we might not be able to sell.
I think the most important part of this may be whether you think that house is worth the $532,166 or worth the $339,586.
When we get into the dialog with the seller and their agent, shouldn’t we be thinking of the “total cost to own”?
If you can convince yourself that a fair price is $250000, do we agree on $530k? Like it or not, this is the cost. Those are real dollars to be paid.
(30*12*1339.35+50000)
(15*12*1608.81+50000)
—-
This argument is less about which payment strategy is preferable and whether the expense is justifiable.
I think most of the flexibility vs. shorter term debt debates are a consequence of age. Most older folks I’ve known are Gung Ho about 15 years while most younger folks (e.g. bloggers) are into the 30 year mortgages. We like the option of doing other things with our money… like taking a nice vacation or maxing our our IRAs instead of tossing money into our home.
Maybe this is because we know we’ll likely move again in 7 1/2 years. When most older folks buy a home (say around age 40), they will likely live there the rest of their days and want to pay as little interest as possible, plus they probably have a higher paycheck than those in the 20-30 age range.
@Adam: I see your point, but I think Matt clarifies what I mean better.
@Matt: Great point. The main reason we aren’t paying off our mortgage faster is because we’ve decided to put money in our IRAs instead. It’s a portfolio diversification issue — we don’t want 100% of our “wealth” tied up in the house/mortgage.
I was unable to afford the payment for a 15 year mortgage so I chose a 30 year fixed rate at 5.875 apr. I owe $38k. I am paying an extra 10% per month which will pay the thing off 7 years early.
NDP (am I allowed to turn your name into an acronym? lol),
I completely agree and I did some real hardcore math on the situation:
http://www.myjourneytomillions.com/articles/15-vs-30-year-mortgages-longer-is-better/
I did the “30 year, but treat it more like a 15”. It’s especially useful if you can apply lots of cash in the early years when the “P” part of “P+I” is low. I wasn’t able to quite double up, but always sent in at least a little extra.
I’ve owned my own house outright for about five years now – it’s great to be in that position by your late 40s, early 50s. (PS, bought around age 30 – those of you that are buying even younger are in an even better shape).
My mortgage is a 30-year fixed, which I took out mostly because I couldn’t afford a 15-year fixed. But in times like these it becomes painfully obvious that the 30-year fixed mortgage is a much better idea because of the flexibility you mentioned. I will say that a 15-year mortgage has it’s place. Say 5-10 years from taking out your 30 year mortgage you have an opportunity to refinance at a much lower rate. Wouldn’t it make sense to then use a 15-year mortgage so you’re not on the hook for another 30 years of payments. I suppose it depends on the magnitude of the mortgage payment versus your income.
MGL is right. Rates are at historic lows—not much more room to drop.
The “flexibility” argument is bogus. If you’re not investing while paying off your mortgage you bought to much house. If you can’t afford a vacation, or at least some blow money now and again, you bought to much house.
If and when you sell your house, you get out whatever equity (assuming you wait till the storm passes) you built up—which is almost non-existent in a 30 year for almost the first 1/3rd of the note. Why not rent if you’re going to do that?
I don’t see why anyone would want to pay more interest—unless you own the bank, it’s a rip. Buy less house—more debt equals more risk.
@eric – You can say it is bogus, but I wonder what the percentages would be if you compared 30 year to 15 year mortgages. I’m not saying that makes it right — there are a lot of people in debt and that doesn’t make debt okay — but in this case I think this is an exception.
I would bet most Americans have 30 year mortgages. You’d have to run some real specific math to figure out all of the costs and opportunities involved. What about inflation? Tax write offs? Equity built up on 15 vs. 30?
A lot of variables to deal with.
I’d make the counter-point that if people just ate out less they’d save significantly more money than taking a 30 year vs. a 15 year! ;] I mean really—I’d challenge anyone to look at what they spend at restaurants in a month and compare that to the $ difference between a 15 and 30 year note! I think a lot of people would be surprised.
Most Americans do have 30 year notes—but that’s because we’ve been trained to do so by our neighbors, our banks and our parents—does not make it smart! Banks love it of course due to the huge amount of interest they’re going to make. If you ask most people why they have a 30 year note I expect most will not have a good rationale outside of “the monthly payment was less”. That is a dangerous metric on which to make financial decisions!
what are your specific concerns re/ inflation? The faster I get out of debt, the more money I have to grow to counter-act inflation.
You can get the same tax benefit by giving away money to charity as you can by paying the bank interest—10k to the bank is the same as 10k to Habitat for Humanity.
On that same point, a lot of people say they don’t want to pay off their mortgage for the tax write off. Maybe this is your point? Let’s say you had a 100k note and paid 5% on it for easy math purposes!—so $5k/year in interest. I can deduct that from my income for tax purposes. IF I had no note, and no deduction, I’d have an additional $5k in income. Let’s say I’m in the 30% bracket—so I have an additional $1500 in taxes. Net result—I can send the bank $5000 or the government $1500. I’d rather save the $3500!
Or I can pay off the note, have more money in my pocket and give $5000 for the same write off if I really want the write off.
I just don’t see an upside for a longer note. Equity is an even more lopsided argument. If most people move in <10 years—on a 30 year note you hardly have any equity in your home. On a 15 you will have a fair amount.
Agreed there are a lot of variables, but most of the arguments in favor of longer notes don’t stand up to scrutiny. It’s kind of like an old wives tale—people do it, but they don’t know why really.
“” It’s kind of like an old wives tale—people do it, but they don’t know why really. “”
They choose a 30 year mortgage because it’s better than renting and they are the safest mortgage product available for 1st time homeowners.
is it though? owning a home has more upkeep costs (think hvac, plumbing, roofs etc.) that need to be acknowledged—-it’s not a 1:1 comparison to renting.
And again, if you move in <10 years, you hardly have any equity to speak of and of course you’ve also been carrying a significant note that exposes you to more risk.
More debt, or a longer length of time in debt, does not equate to safety. I would propose just the opposite. A big down payment on as short a note as possible is the safest option if you’re going to buy.
I think a lot of people choose the 30-year mortgage because it leaves them the option of making a lower payment. You can always make your 30-year mortgage payment and contribute towards principal with the rest of the money to match a 15-year mortgage payment. This doesn’t quite match up 100% with the amount of principal as a 15-year mortgage, but it’s close and it leaves your flexibility for the unknown future. Say you lose your job and want to only make the minimum payment, you don’t have that option with a 15-year mortgage.
You can’t just say that a 30-year mortgage makes no sense in any situation.
A large down payment and a shorter note may be the safest option, but how many people have the finances to afford those options? Should people who can’t afford a large down payment and a 15-year note not be able to enjoy the benefits of a home? There are just different options for different people in different situations.
@ eric_wan
Did you buy a piece of crap house or Realtor screw you over? You seem a little jaded.
A longer note is less risky b/c you have a smaller monthly payment and less risk of default. For 1st time home owners, that is the safest option. If you haven’t heard, we’ve seen a higher than average bump in foreclosures thanks to shady mortgage products.
As for upkeep costs, those costs shouldn’t be a major factor if you do your due diligence prior to buying. Sure pipes burst unexpectedly and mother nature might drop a tree onto your roof, but that is what insurance is for.
Not enough! hence the largest government bailout in history! ;]
Seriously I would say “no it’s not wise”. A house can be a blessing, but it can also be a curse! Just check the latest bodycount from the news headlines about foreclosures—-THAT is the outcome of ‘different options’—banks are great at options, ARMs, interest only notes, 40 year notes, reverse mortgages etc. see a pattern yet?
Just remember that debt is a product—it is sold to us everywhere. It is expected that we have some and cherish it! That it is the way to reach our dreams. House buying is no different.
There will still be plenty of 30 year notes done in the future, I acknowledge that, I’m just pointing out that debt =’s risk and that banks are fantastic marketers.
If you can swing a 15 year note, you should, otherwise, you should really evaluate your budget and eat out less! ;]
LOL!–No, fine house, great realtor—I’d recommend everyone use one vs. FSBO!
No, I just don’t love paying interest and I can use a calculator! ;]
Why anyone would want to keep funding banks is beyond me. We, as a culture, are SO into debt we don’t even see it anymore. This is a red pill person living in a blue pill world I guess. I just can’t live in the illusion anymore.
A 30 year note is not safer. Heck why not a 40 year or 50 year note then? why even attempt to OWN the house and just rent forever?
If my monthly payment is the metric to use to make financial decisions I’d rent everything, not own anything and have debt until I die. That’s nuts.
The risky mortgage world is the outgrowth of creativity by our banks—but people, home buyers, signed up for the trip—and both are going to take a bath.
If you live in a house longer than a year or so, regardless of your due diligence, things break. Washing machines need to be replaced, roofs need re-shingled, etc. Just a fact—I’m not saying it’s a huge cost, but it’s there and does make owning a home more expensive generically than renting.
If all this stuff makes it more expensive to own your home vs renting then how does anyone make money by renting the houses out, it sounds like they are subsidizing renters. I know that people are not losing all there money renting out so explain your thoughts on that one.
I understand the math you’re doing, and yes, a couple hundred $ less in payments when you’re out of work could help.
But! (you knew it was coming) I’d complete the picture you’re drawing and add that I’d have a pile of cash sitting idle for just that issue.
I maintain a “rainy day” fund—about 6 months of expenses—just in case. If I lose my job, I have a bit of time to get that next job, or time to make the harsh choice and get about selling the house and go rent again if I needed to.
I understand your point, but people very rarely follow through on paying their 30 like a 15. Life happens and they eek by with the minimums. It’d work if people did it, but it’s not very common.
Cool thing about the 15 year is that it pays off in 15 every time!
Phillip—-I’d argue the ones that are making money on rentals have very little to no debt on them. They buy investment property with cash so they can ride out the bumps.
The ‘no money down, make $100k at home’ guys on TV are all hyping debt schemes. You finance X and have a $100 payment (for example). You rent it for $150 and are a happy camper. You do that 10 more times and life is good. Then someone moves out and you can’t rent the space, or you lose your job, or whatever, and next thing you know, the cash flow reverses and you’re selling properties just to dump them and be free of them.
The only folks making money in that model are the guys selling the tapes!
Seriously, debt-fueled cash flow is a dangerous game to play. Some people have made money doing it, but it is *risky*.
if you want a rental, buy it with cash and you can weather market issues like we have today. In fact now is a fantastic time to buy due to the distress out there.
Hey I’m with you on repaying debt as quickly as possible. I pay extra principle on my 15 year mortgage b/c I don’t like paying my banker’s annual bonus. I’m with you on most every single comment you make on debt repayment, but I think 30 year mortgages fill a much needed role in our economy for first time homebuyers and low to middle income families.
For upkeep costs again, I don’t see this cloud of doom and uncertainty you foretell. I put maybe $250 into my first place (with a 30 year). I dropped $50 for shrubbery and $200 for paint, and all b/c I did my due diligence with a home inspector and buyer’s agent. The HVAC was < 10 years old, newly carpeted, and held it for 5 years (rented it out for 3) without any supernatural tragedies. Because I timed the market, I actually had my house pay me not to mention the extra thousands I made from renting it out.
I’m saying this respectfully — not trying to be a wiseass here.
As for 50 year notes, they’re a horrible idea. But 30 years are the traditional, fixed rates that have proven widely successful for less than affluent families who want to OWN their home since post WWII. Let homeowners pay a lower monthly payment so they can be the “good consumers” our society pressures them to be without burdening them to be mortgage poor.
Let people eat out if THEY choose, b/c not everyone is as paranoid as we are when it comes to someone making money off of them. Let folks enjoy their lives to the point where they aren’t confined by someone else’s beliefs. If they fall for the consumer influenced pressures, that’s their choice (or stupidity), but at least they can repay their mortgages and we don’t have to repeat this whole bailout process again in the future.
Wow. I step away from my blog for just one second and you guys go to town. I love it. Keep the discussion going!
I’m not saying a 15 year mortgage is bad. Definitely not. I’m also not saying that paying off debt faster is bad. That’s kind of the point of this website.
But I think it is quite a folly to equate a 30-year fixed mortgage with the types of mortgages that have caused the foreclosure boom (ARMs, no income verification, 105% financing, ignoring high debt-to-income, etc.).
You are right, a longer term is going to cost more. You are right that banks make money off of them… that’s kind of the point for the bank.
It would be great if we could all buy homes with cash. That’s simply not reality. Just because most people don’t pay their 30 like a 15 doesn’t necessarily make a 30 a bad option. What about the people who do pay it down correctly? There is still a little bit of cost difference, but I think the added flexibility is worth it.
Carry on. Great discussion.
@Matt–I haven’t had a ton of additional costs on our house either, but the reality is there’s more you’re responsible for when you own vs. when the landlord’s on the hook. Point being it isn’t 1:1 exactly so ‘own’ vs. ‘rent’ is different.
I’ll call you lucky or wise on the market timing thing—good job—not sure I’d do that but like I said it can be done, your example being an obvious case!
You said “traditional”—that’s always a flag for me! I agree it gets people into a lower monthly payment, but is it really smart to sign up to pay 2-3x or more in interest? I agree—someday—they’ll pay it off, but I just don’t see the upside.
If they can fund the 30 but struggle at the 15 year payment, they are running a pretty tight budget wouldn’t you agree? If the payment is $200-400/month more, that’s just not a lot of extra cash—and if that is what they then consume with and make all our lives better for it—they are still living close to the edge imo.
My point would be that in that tight of a model, their ability to repay is kind of an illusion—or at least it’s a lot dicier than they might admit. That’s assuming they have no other debts or ‘life changes’ happen to them!
I don’t think there’s any way we on this board are going to get 1 less order of fries super-sized!—our discussion here is a whisper compared to the cultural megaphone. I’m all for personal choice, but I’d also hope that education on these topics makes its way to more people. Maybe we tell our friends, or help them do the math? All I know is that ignorance and an inability to do math/greed got many people (bankers included) in hot water. And I don’t want to write any more checks for this particular freedom! ;]
I think the flexibility argument is pretty thin. Like my last post—if you’re saving a few hundred per month between a 15 vs. a 30 year note—and you lose your job. That difference can save you some, but aren’t you still in “oh crap!” mode?—I mean maybe you hang on a month longer but it’s not a game changer really.
I’d advocate for a big pile of cash as an alternative. Yes, I know that’s weird—but it is of GREAT comfort to have on hand. That will give you some flexibility–or at least more staying power in tough times. It’s not a panacea, but it provides a cushion of sorts. Think of it as your own insurance fund.
Just an aside—has anyone ever seen the “House Hunters International” show? it’s the HGTV show but they do it overseas. I’ve seen it a couple of times, but the time that sticks out to me was when they were in Italy. This couple lived with her parents for almost 10 years and saved up for the 100% down plan…it was amazing even to me, but very cool. Could I live with my parents for 10 years?—doubt it! I only bring it up to remind us of our cultural lens.
I fully agree with Eric’s post. If we look into other societies e.g. in Europe and Asia, the people handle mortgages, debt etc. much more carefully and conservatively. A rule of thumb for financing a middle class home e.g. in Germany is: 1/3 bank mortgage, 1/3 low interest mortgage (3%) from a “mortgage saving plan”, 1/3 cash down payment. Many immigrants have also a pretty good understanding of handling debt and interest, etc. Friends of mine immigrated into the US 16 years ago. Today, the couple owns an apartment and a house in NY,Queens. How did they do it without having a big paycheck? They had short-term mortgages and paid extra money whenever they had some money left. Their motivation and goal was: try to pay as little interest as possible; own your property as early as possible.
Good for them!
There are two factors in favor of a 30 year mortgage that I think should be considered: inflation and opportunity cost.
First, when you have a large mortgage, inflation works in favor of the debtor. Thus, if interest is very low (5% as of today) you can lock into use someone else’s money for a long period of time.
If inflation averages 2% over the next 30 years, you have an effective 3% interest rate. That is, you get to pay the bank back in inflated dollars.
Of course the mortgage interest tax deduction reduces your tax liablility, for me at about 25% of the interest paid. At 5% that reduces the after tax deduction interest rate to about 3.75%. Now bear in mind, that also does not calculate in that you are paying after-tax-deduction interest in inflated dollars.
Finally, the money that you don’t spend paying down your debt is better spent investing. The market historically returns about 9% over a 30 year period. Thus, you borrow at 5% and make 4% on the spread. That does not factor in that interest is 3.75% after the tax deduction, nor that you are paying back with inflated dollars.
If the interest rate is 5%, the tax deductiona and inflation give the debtor the financial advantage.
My 30 year strategy is “riskier” but considering the market’s historical returns and the current interest rates, this is a financial risk I am comfortable with. If you are more risk averse, wait for interest rates on t-bonds to rise above 5% and then move your money there. But I think the 15 year is far too cautious.
Moreover, I agree with the aforementioned comments that discussed portfolio diversifaction. All of your money should not be in one asset, your home.
Not all debt is bad. Debt that subsidizes excessive lifestlyes is bad (don’t use the 30 year mortgage as an excuse to buy the biggest house you can afford).
However, low-interest debt can lead to financial success if used wisely and prudently.
couple of points.
if it was wise to keep my mortgage for 30 years, why not 50 then? or more?
if your house was paid off, would you go and borrow say 100k against it to invest in the stock market?
your answer would be ‘yes’ following your logic, but I’d bet 99% of the people reading this would say ‘no’—why is that? Because people can *feel* the risk when you pose it that way—-and they’ve seen their portfolios drop by 30-50% in the past few months! They’ve seen the risk up close.
Yes, real estate is an inflation hedge—but that fact doesn’t motivate me to pay a few times more interest to the bank. It’s a hedge either way.
I’m a firm believer in investing over the long haul, and I don’t own any bonds—return is to low. However, if my house is paid for (and I have a nice pile of cash on hand), I’ve reduced my risk substantially and still have the inflation hedge, and of course I’m saving a ton of money in interest payments to the bank.
I prefer the 30 year mortgage because it is a nice medium between paying off the debt eventually and having cash to invest. Somewhere on this website their is a graph that shows the relationship between the amount of payments and time it takes to pay off the mortgage. The thirty year mark is where the line starts to flatten out. Nonetheless, if my family grows and needs a larger house than what I have now, I will take out a mortgage to purchase it rather than sell stocks/bonds because I think a mortgage is cheap money.
Most corporations have large debt. Why? Because good debt is a good way to grow. Similarly, with inflation, low interest rates and the tax credit, using your money to invest rather than payoff a mortgage is a healthy strategy.
I would add that those who invested in bonds last year did very well when stocks and interest dropped. If you are a true long term investor, and can handle the temporary swings of the market, than you should not be phased by the temporary downturn–even if you are all in stocks.
Nonetheless, having a well diversified portfolio allows you to sell some bonds when stocks are low and bonds are high, and sell some stocks when stocks are high and bonds are low.
I think the risk you speak of is a feeling. It is an emotion. It is not based on logic or long term financial planning. And most people over estimate the risk.
Also, my point was not that real estate is an inflation hedge. Rather it is that inflation benefits debtors.
Well whether I would borrow 100K against my home depends on a number of factors. What interest rate can I get? Will I be able to deduct the interest on my taxes? What will the monthly payment be relative to my income? Do I have sufficient cash reserves or cash equivilents to cover living and debt services for a sufficient time?
In my experience home equity lines of credit are more expensive than a purchase mortgage. I think the tax rules are different too. So I would be inclined to say no, and not take out a loan against the house. But that all depends on how the math works out.
Give me some examples.
One more thought. My 30 year mortgage preference is based on current interest rates for fixed mortgages (about 5%). If rates were to rise back up to 8 or 9% than I would say that the 15 year mortgage is probably a good bet because the 30 year strategy provides for an unbalanced risk/reward.
Loving this discussion. Keep it up guys. 🙂
Sometimes I wonder if historical returns will be good indicators of future returns. I hope so, but a piece of me doubts it.
There is one thing for sure. Paying off debt is a known return. Yes, I wouldn’t want 100% of our net worth tied up in our house. Then again, if your house is paid off, you have a place to live no matter what happens. And I think that is powerful.
couple more points!
most companies use debt?—not Microsoft, Cisco, Google, Apple, Qualcomm, Walgreens, Ebay, Adobe, etc.—-not everyone uses debt. And now these companies look like geniuses vs. begging Washington for a handout. Most MBA students learn all about leverage, but a. it’s not required for success, and b. might lead to you looking for a new job!
If you have to have a 30 year mortgage to allow you to invest, you bought to much house. A 15 year is normally a few hundred/month more—if that hit stops you investing, you are living on/close to the edge already!
Bonds are “safe” but normally don’t offset the losses due to taxes and inflation over time. I’d prefer to take some calculated, diversified risk over the long term that will keep me ahead of taxes and inflation.
No the risk I’m talking about is very real. Foreclosure requires a mortgage! If you take out 100k on your house you’ve actually put your house on the line..if you don’t pay, they will foreclose. That is not theory. And I’d still bet that 99% of the people you ask that question to would not do it either. I don’t need to figure out my marginal return to know that risk is real.
Say you’re paying 5-6% now on your mortgage—and you can make 12% in the market. Take out your taxes/inflation (say 3-4%), so you’re now comparing the risk of a 12% investment vs. a 9% cost. So for 3% you’d leverage the house your kids sleep in? You can play with the numbers, but the fact is it’s very small money for an unreasonable risk in my book.
I’d suspect you could find 3% in your monthly budget—-with no risk whatsoever! ;]
Exactly Kevin—-paying off your house is a guaranteed return when you drop your mortgage interest! and you have a safer future (with an inflation hedge to boot).
I think you have to do both—take advantage of the market and compound interest, but also play good defense by avoiding debt as much as possible and living on a budget. Sounds like Grandma huh?
You certainly picked a great topic for a lively debate. I think the interesting variable in this debate is the differing opinion about debt related to the commentor’s age. Ten years ago, I would have said a 30 year is the way to go. Now that I’m in my low 30s, I lean towards the more conservative 15 year. Funny how our opinions towards debt change over time.
You also mentioned historical returns… funny how I don’t hear many financial gurus talking about the historical return on the stock market is 10%+ these days. That was the key selling point a decade ago.
BTW – new theme looks awesome with the exception of that Big Orange dominate color. Might I suggest some Gator Blue to go with it? (((joking)))
Good point Matt, I am in my 30’s. Maybe my perspective will change with age.
Good point on corporate debt, Eric. Touche.
I think the 30 year or 15 year debate comes down to market conditions and your assesment of the risk. Like any other financial decision it takes into consider weighing the various factors that affect risk.
I think it is foolish to say, the 30 year is always better. Its also foolish to say the 15 year is always better. Rather, than a blanket rule, I think you must make a decision based on market conditions.
The present economic environment has done nothing to disturb my view of historical returns. I don’t invest for one year periods of time. I invest for 30 years. Because of that, I am not scared by the present environment.
I think if you have enough savings/investments you will be able to fend off any foreclosure. If you took the extra few hundred bucks and blew it on latte’s, well then you have no excuse.
I think it is a better financial choice to invest the money rather than pay off the debt on a 15 year schedule–at least in the present economic environment (low interest, cheap stocks). The 30 or 15 year debate has alot to do with the proportion of your portfolio dedicated to home-equity and to other investments.
Eric, I don’t understand the numbers that you gave me. Could you explain?
Also, if you’re worried about foreclosure, a lower monthly payment makes it easier to avoid foreclosure (as in Kevin’s strategy outlined at the top of this article).
I think if you combine Kevin’s strategy and my strategy you have the highest protection against a foreclosure. The one thing I am modifiying about kevin’s strategy, is to not pay down the debt when you have the money, and instead investing it.
Suppose you have been diligent for 10 years and used the excess money to pay down your debt as Kevin suggests. However, catastrophe strikes. If you’re late, the bank will still foreclose no matter how much equity you have in your home.
If instead, you had put that money in safe investments, and when times got tough and you couldn’t pay your mortgage, you could sell stocks/bonds. Obviously, if you have other assets (beyond your six month reserve), you can buy yourself much more time in the event of a catastrophe (that is so severe that it has depleted the six month reserve you already saved).
Having more equity in your home will not buy you more time (unless you sell your home–which isn’t always an attractive option).
EVERYONE: I made a serious typo in my original calculations. A reader just e-mailed me to point this out. I’ve added an UPDATE to the original post.
Bottom line: You save even more money with a 30-year mortgage than I originally calculated. Applying the full difference to the 30-year mortgage will have you paying it off in 15 years and 6 months rather than 19 years. A serious difference!
Thanks for your continued readership and keep up the great discussion. I apologize for the error.
“If you took the extra few hundred bucks and blew it on latte’s, well then you have no excuse.”—exactly! Most folks SAY they’re going to pay a 30 like a 15 but rarely do. I’ll have to dig up the article but the vast majority of folks have ‘life happen’ and they chew up that extra payment. Think how many people rolled their consumer debt (groceries, vacations, clothes etc) into a HELOC, or 2nd of some kind!–so they’re financing a steak! Cool thing about 15 year mortgages is that they always pay off in 15 years—no extra work/math involved.
Re/ investing the difference—I’d rather live lower on the totem pole, invest 15% of my wages AND have a 15 year note. Call me crazy but I don’t like the idea of paying the bank 2-3x the interest on the 30 year note. That savings is again guaranteed—the stock market etc. can’t give you that assurance or return.
Whether it’s a 15 year note or 30 year note when it comes time to foreclose won’t matter of course—and whether you spend cash you have on hand or cash out investments to offset income lost due to job loss is only a temporary fix—that is not a house-saving/long-term fix. You need another job, right? And if that failed and you had to bail/sell the house, you’d walk away with a smaller balance with the 15 year no doubt about it. Taking the difference and investing it a. assumes people actually will do that, and b. doesn’t solve the real issue (job loss, major medical hit etc.). If you don’t get a new job, game over either way.
The ‘would you borrow $100k on your paid for house to invest in the stock market?’ question—–if you can make 12% on the stock market over time, and have a 6% note, you’re looking at 6% max return. If you account for inflation and taxes, you’re really coming out close to a couple % return. And again, I would bet 99% of the folks you ask that question to would answer “no”. Why? because their heart (where risk is measured) knows that it’s not worth the risk. Our conversation here has largely revolved around the calculator, and that does not paint the whole picture.
The choice is “make a couple of points in the stock market or have a paid for house”—especially today I think the answer is obvious isn’t it? You can only get foreclosed on with a mortgage!
@eric In a previous post, I answered the question would I borrow 100k on my house and invest in the stock market “no.” We’re in agreement on that point.
I think that if you have more investments (and less home equity) you have a larger cushion, and hence more time to look for a new job, but that is just my perspective.
“Accounting for inlation and taxes you’re coming close to a couple percent return.” How do you account for inflation and taxes? Please show me the accounting because I don’t fully understand your point in how the numbers work out.
@ Kevin. With that calculation change in mind, how does that affect your decision on the lump sum vs pay off debt as you go?
@dan, taxes on investments differ depending on how long you hold your investment. if you buy a stock and sell it within a year you are taxed at your income tax level. if you hold it for over 1 year you are taxed at the capital gains tax rate. right now it is currently 15% if obama doesn’t try to increase that tax. so basically if you hold it for a year, uncle same takes 15 cents for every dollar you made in your investment. also inflation is something you can look up. usually when estimating, you can use 3% as an estimate. Precise fluctuations can easily be looked up by looking up the long term risk free treasury rate from any website. St Louis Fed, the Us goverment treasury, etc. You subtract that off your growth rate as well.
Keep in mind, the 401(k) limit is now $16,500, that’s $33,000/couple. I’d prefer the 30 as well, and fund the 401(k) to the maximum. Money paid back to the mortgage is really money tied up until the house is sold. Sure you may get a HELOC, but that’s not a fixed rate. These are the lowest rates you’ll see for a long time. You’ll soon find you can buy 1 yr CDs that yield more than you are paying on that 30 year mortgage.
Others will have a different view, but I see nothing sacred about paying of the mortgage. High interest credit cards are another story.
RE: Keep a low mortgage payment and invest the difference.
Forget paying off your mortgage. Invest in a bond fund (6% return over 10+years) instead of paying extra.
Keep in mind this fact: mortgages are SIMPLE interest. If you invest in bonds (or stocks for that matter) you are gaining COMPOUND interest.
Compound interest is the key to wealth.
Gaining even 4% compound interest is better than paying off a 5% simple interest mortgage.
Food for thought. Even Warren Buffett keeps a mortgage on his home…and this is the reason why.
Matt, on a 30 yr, 6% mortgage, if one were to pay $100 along with their first mortgage payment, they would save $500 in interest. Simple interest would be $180 as 30 * 6 = 180.
Cite your source for Buffet having a mortgage. I don’t know that he does or doesn’t but I doubt that he’d bother with one.
Completely agree. Buffett has owned the same home since 1974(?) in Omaha. There is no way he has a mortgage!
I’m a simple believer that the longer you pay for something the more it costs. Hence, less time to pay-off equals more time for ownership to me. I am a big believer in accelerating mortgage pay-offs by aggressive prepayments. It is hard for someone to take a home away from you if you own it, but I have witnessed many retirment accounts of my friends, including my own, which have been invested in mutual funds for years drop by 40% in value. Recovery will take a very long time. Hence, I have a 15 year mortgage that I have been prepaying on and have I reduced the remaining time by 24 months (as of last month), That is a lot of interest money the Bank will not earn and I have saved. While I agree a 30 year mortgage provides you flexibility in money usage, it is still 30 years and that is a long time to prepay. Excellent question for pondering!
@dan—yes, Aspirations purse is right—say you’re making 12% in the stock market (just assume over 20-30 years) and you’re paying 6% on the mortgage. Take out 3-4% inflation and a couple % of your gain due to capital gains taxes and you’re about even comparing the 2.
People often forget taxes and inflation when doing that comparison. The other variable here is risk—and that too has a cost. If my house is paid for I reduce that risk to 0. I can’t be foreclosed on—however if I lose my job, and my 401k tanks AND I have a mortgage—different story entirely.
I’d also like to see the reference to Buffet having a home mortgage. I’d be shocked honestly. The guy is a cash player and is making out like a bandit now.
eric_wan – time to get your spreadsheet out. I don’t and won’t claim a 12% return is reasonable. But to suggest that the difference between a 12% return and 6% mortgage is minimal is nonsense.
The 12% return, if dividends and cap gains, is taxed at 15% max, yielding 10.2%. The 6% is deductible against ordinary income and my property tax/ state tax covers my std deduction, so 6% costs me say 4.5% (25% bracket). You want to assume 4% inflation? OK. The mortgage costs me .5% (that’s 1/2%) and the stocks return 6.2% real return. Tell me how this is about even. ( I would use 8% for stocks, 6.8% after tax, 2.8% after inflation. Not that huge spread, but still, a difference that adds up over time.)
12% was “rosy”—granted, I was starting there to illustrate. 10% or less is even uglier.
6% difference, – inflation
– taxes
– risk
= not a great argument for a 30 year note. That was the whole point of this thread really—that 15 years of additional interest/risk is offset by the great returns over that time.
And you’ve proven my point. 2.8% – risk is close enough to zero to confirm for me that that argument makes no sense. Everyone else lined up for 15 more years of risk and those awesome returns—more power to ya! ;]
Erin – First let me say, there is no ‘right’ answer. Only what lets you sleep best at night.
You talk about risk. But you are taking on ‘more’ risk for those 15 years by committing to the higher payment, aren’t you? Sticking with the 6% mortgage/25% bracket, it would take a 5.29% gross return to break even using 15% cap gain rate. If one is disciplined enough to put that money aside, they will have more than enough to pay the mortgage balance at the end of 15 years, but during that time, they’ll have the money should an emergency arise. 10 years into your 15 year mortgage, what would you do if you lost your job? With no income will the bank lend to you?
What if for someone the difference between 15 and 30 yr payment is the difference to being able to fund their retirement account? A matched 401(k). That change your view?
Nothing exists in a vacuum. For some, your plan is ideal, for others, not. People in general are so financially illiterate they wouldn’t even follow this dialog. Too bad about that.
True—I don’t want to sleep on the street—that’s one of my motivators. This conversation can’t happen in a vacuum either! Before you took on ANY mortgage, I’d hope you had a reasonable pile of cash to catch “life” as it happens—co-pays, roof leaks, dead engine etc.
You’re right on the math, but how many people really have that kind of discipline? like 3! Cool thing about the 15 is that it pays off in 15 each and every time!
If I lost my job, and I was diligent and had cash on hand I would struggle—likely working 2 or 3 placeholder jobs while the ‘good job’ hunt went on. But that isn’t any different than if I had a 30 year note—in fact I’d have more equity in my home so if I had to sell I’d likely walk away with a bigger chunk of $. And that’d be tax-free money to boot vs. having to cash out my 401k and pay taxes on it etc.
Re/ the 401k match—again in the context of life I would hope that the borrower would have that entry in his budget BEFORE he went shopping—so he could afford the house AND make his contribution. There’s no reason he/she couldn’t do that except for house fever! too much HGTV.
I agree—the sad part is that very few folks will read/adopt ANY of what we’re talking about here! That’s why I trend to the very simple/very conservative. It’s great to be able to have these discussions—too bad very few (none?) of these will happen at the loan officer’s desk!
As to “discipline”, what you want to do is automate the whole thing. Of course you would fritter it away if you left it someplace where it can be “frittered” from. Instead, put it someplace where it won’t require “discipline” to avoid frittering it away.
Get a separate checking account for the mortgage payment. Transfer the amount of a 15 yr mortgage payment into it every month from your regular checking account. And send in an auto payment for that amount to the mortgage company every month.
this sequesters the cash away from the rest of your money so it isn’t visible. And what isn’t visible cannot be mindlessly frittered away.
If something comes up and you want to drop the payment amount to just the required payment for the 30 year mortgage, then you will have extra in that second account. And will have to make it available for other uses. This little extra step required helps in getting across that it is an unusual thing and not something that will be happening all the time.
The one thing EVERYBODY has missed in the mortgage equation is this, any dollars you borrow are worth more now then in the future, hence the longer the mortgage the less those dollars are actually worth in the long run,due to inflation ,if the u.s. ever again suffers hyperinflation , which is quite possible, maybe even probable with the way the govt. is printing money these days [only a fool thinks its going to get better],those dollars you are paying the bank years from now will only be worth a fraction what they are now, which means a longer mortgage at this point is more beneficial, even though I always thought shorter was better, at least up till now.
So you bought you house in yuan or euros? inflation would affect the value of the dollar and the dollar-denominated asset as well.
If that kind of thing happens, saving a few bucks on your mortgage payment will be the last thing on your mind.
and yes, though the gov’t has gone quite far in ‘quantitative’ easing, there is no sign of inflation on the horizon like you’re talking about. Nor is there really any alternative to the dollar as a reserve currency—-someday, possibly, but not for years to come.
With mortgage rates as low as they are today, the average person is better off with a 30 year loan. With the lower payment you should be able to invest the difference and get a greater long term return. If you have a tough time saving and would just spend the difference, then the 15 year is a wise choice. Each person is different…
No they’re not. The average person has about $8500 in credit card debt, has no budget, is not saving for their kids college and really has no clue about financial discipline. The readers of this blog?….maybe they are atypical, but if you want to talk about the average American, they are relatively clueless—and in that light, a shorter term note is far safer, as the average American will NOT save the difference. They’ll spend it, or lease/get a loan on a new car etc.
And you are committing the fallacy of not including risk/taxes in your investment math—-the return on that difference is very dicey given our current environment of investments (where exactly can you guarantee a reasonable return right now?). I can guarantee you that inflation will rear it’s ugly head and taxes are only going up! ;]
I agree that *some* folks could make it work, but it’s not the slam dunk math-wise that you think—it’d take some luck! and the average person is just nowhere close to being able to make it happen—look at their track record.
The 30 year note is a banker’s creation—it has no basis in math as being a better “product”. It’s just what’s been sold primarily for years and years as the smart move.
I LOST MY JOB, BUT MY HUSBAND STILL HAS A JOB. WE HAVE ONE INCOME AND SINCE WE HAVE A 30 YEAR MORTGAGE, STILL I CAN PAY MY LOWER MORTGAGE PAYMENT. THE SITUATION WOULD BE DIFFERENT IF I HAVE TO PAY THE 15 YEAR, HIGHER MORTGAGE PAYMENT…
WE HAVE 401K, BUT IN THIS ECONOMY I WOULD HAVE TO TAKE OUT LOT OF MY SHARE TO GET THE SAME DOLLAR VALUE I HAD 5 YEARS AGO. I DO NOT EVEN TALKING ABOUT THE 10% PENALTY AND TAXATION.
I AM TOTALLY AGREE: GET THE 30 YEARS MORTGAGE, PAY EXTRA MONEY IN TO IT, BUT LIVE THE OPTION OPEN.
If you are say an Obstetrician who is always getting sued you WANT to have a big mortgage loan so the property is encumbered and lawyers can’t take it. Also you want to lease a car and put the max into a pension (off limits to creditors.)
As far as stocks MMAs CDs etc could put into a family trust but even that’s not bombproof
It is hard for someone to take a home away from you if you own it, but I have witnessed many retirment accounts of my friends, including my own, which have been invested in mutual funds for years drop by 40% in value. Recovery will take a very long time.
Sorry to hear that Aniko, but I bet you could make the difference by halting your contributions to your 401k. Don’t take out the money though—penalty + taxes is 30-40%!—ain’t worth it. I still don’t buy that as an acceptable reason to have a 30 year note, and you will get another job—don’t lose hope!
@TB…huh? that’s what malpractice insurance is for—which docs have to carry anyway. And leasing is the MOST expensive way to acquire a car. Your logic would dictate leasing everything your whole life—no equity built up so you can’t get sued and have it taken away? Buy insurance—transfer the risk–that’s what it’s for.
@ Finance—not only is it hard, it’s impossible. Foreclosure only happens with a mortgage balance.
eric – if inflation returns, isn’t it better to be a borrower than a lender? I have the bank’s money, fixed at 5.24%. In the 14 years since I moved in inflation has made the value of the remaining balance I owe less than half. i.e. these are cheaper dollars.
As far as risk is concerned, I’d rather take the 30 and know that I have the extra cash each month, that small rate difference wasn’t worth it to me at first.
On the other hand, when a rate drop was enough to refinance to a lower term and not have the payment go up too much, I did that, and now have less than 7 yrs left, so all in all about 20 years, but at the beginning, the 15 yr payment would have been tough.
Great rate!—but you’d have a cheaper rate w/ a 15 too, and you’re building equity faster, so in fact you’d still be better served as your home would appreciate faster with that rising inflation—of course you need to have a fixed rate either way in that case! if you owned outright, your house (likely your largest single asset) will ride up with the tide—no risk either.
True, I understand that the 15 is a tighter plan, but *most* people don’t do a written budget—-so they really piss away a lot of money since they’re not tracking it. I suspect more of the folks that read this actually do a budget that they stick to BEFORE the month begins, but the vast majority of American’s have no clue where their money is really going. That is a small exercise that could save you 100’s of thousands in interest—-just to sacrifice and only eat out 4 times a month vs. 10. We all know these people!
I mean how many mocha-chinos would it take to bump your payment $200/month?—about 40—so add 1 a day plus a few lunches and a couple splurges at the grocery store and you’ve got literally a ton of money in savings of interest—-and you own the home much much faster.
Kudos on your move! how about this thought exercise—-since rates are a bit lower now (lets just say for arguments sake you could get a 4.5%)—why don’t you go refi back into a 30? I’ll tell you why that causes a bit of stomach churning—it’s risk—no one does the math on risk when they look at the lower payment. If they did, we’d all still be doing refi’s and putting that cash into the stock market, or home improvements, or some other cool investment—-now that folks have been scared straight, that idea doesn’t seem to appealing anymore. They just want to keep their homes—that’s why—imho of course—-the 15 is generically a better deal. More sacrifice, yes, but removes a lot of risk, and saves a ton on interest.
the logic commonly used in these rationalizations is that:
1. they’ll pay the 30 like a 15 (very low likelihood…life happens). 15’s pay off in 15 every single time!
2. They’ll make more money in the stock market or X with the difference in payment. (sounds awesome when a bubble is in effect—not so cool when most every asset class has taken a hit—and no one adds in taxes, inflation or risk..)
2b. since I have a mortgage, I get to write off the interest and save on my tax bill. (you could do the same by giving to charity….and how is paying more interest to save a much smaller amount in taxes sane?—do the math—pay the bank 3-4x what you’d pay otherwise in taxes?—makes no sense)
anyway, the logic is full of holes and is pushed by bankers and realtors—anything to make the sale!!! ;]
you make excellent points. for us the difference from 30 to 15 was $1100. Yes, it was a huge mortgage. In the end, my goal was to have the mortgage end before the kid started college, and we retired.
So I am more conservative than those who would refi now to 30 years to bet they’d beat the rate with their investments.
For us the $1100 was saved for retirement and put into a (matched) 401(k) account, so market return notwithstanding, we are far ahead.
Yikes!—yeah at that end of the spectrum, it’s more than a $200 difference! Average mortgage holder (say about $200k) the difference is a few hundred bucks.
You are also outside the norm by actually investing the difference!—most folks say they will but don’t—or they pull it out at the wrong time.
If you had 15 years though of investing your full house payment, I wonder how much of a difference it would be in the end? you’d also have to put a figure on 15 years of risk to compare them.
The big unknown of course is that if you were in year 16 right now and lost your job—how do you do that math! again, more risk. I’d rather sacrifice more today and reduce my exposure—especially in today’s economy!
Joe and Eric: man, I’m really loving this discussion you guys are having. Keep it up! Great stuff! (Oh, and I’d love to have you as beta testers for my eBook… just sayin’ 🙂 )
I’m close to a conclusion, but –
Eric – at $200K, 6% 30yr = $1199, 15yr = $1687, $488 diff. Drop rate on 15yr by 1/2% and it’s $1634, still $435.
Everything you say is correct. Until one knows the client, the decision can’t be made in a vacuum. Is that extra $435 going to get matched in a 401(k) or spent on big TVs?
My own situation, we were planning a child, and figuring we’d have a cost for a nanny, so our 30yr decision also took the extra cash flow we’d need for about 5 years that we’d have the nanny.
To the “lose your job in year 16” question, I’d say I prefer to have the money in investments and still have a mortgage, as the mortgage is only one bill of many.
The “take the 30 and invest” approach does introduce some risk, I suppose, but consider that at 6%, 4.5% after tax, is that such a high risk? Go back 15 years and I think that with dividends the strategy worked. (The return was an average 7.9%/yr in dividends and cap gains, or 6.74% after taxes, not huge, but this period included the 2000’s a horrible decade.)
This discussion has progressed a while since I last posted. Thanks for all the thoughtful posts.
Eric you talk about the security of paying off the mortgage, and I can sympathize with that goal, but I think joe makes a good point; that there are other bills to pay in the event of a job loss, and having money in the bank, instead of in the house, helps pay those bills.
One thing that I would like to add to this discussion, is whether or not you live in a non-recourse state. I live in Idaho, which is essentially a non-recourse state, meaning that if you default on your mortgage, the bank cannot collect on your investments, and they only get the house back.
Consequently, in my state, there is less risk having more money in investments than in the house because if there is a job loss, you can walk away from the house, and still keep your investments.
Setting aside the moral debate about strategic default, i think you have more options and flexibility to reduce risk if you live in a non recourse state with a 30 year loan.
@ Joe…yeah big TVs…my money is on Best Buy! ;] and yes of course no vacuum’s here, but MOST Americans for better or worse have little to no discipline, so I always skew towards the dummy-proof approach!
And the risk I’m referring to is ‘no mortgage’ vs. ‘having to make the call on selling the house’ IF you lost your job in year 16. The math looks good on the surface, but if you’re not wanting to move your kids, the hassle factor of selling/finding somewhere new etc.—to me that is a risk with a very large price tag on it. You’d have your ROTHs or whatever, but you’d potentially be renting again!
@ Dan—yes non-recourse would be an awesome option, though as you mention, most states don’t provide that. (mine doesn’t)
And I think walking away from a house (aka your home!), is a MUCH tougher deal than we’re acknowledging. Yes, the math is the driver, but there is a huge price to pay for your family and just plain old hassle in selling your home.
My contention is that most American’s DON’T have that money in the bank to pay their other bills. They’d be forced to go down the list—cable, gone, extra cell phones, gone, eating out, gone etc. etc. and at some point they’d cash out their investments to save the house (or not)—either way I think that ‘extra’ money in the 30 vs 15 model is not really sitting there—it has been spent.
I know the math makes it seem safer, but like I said—in year 16 on a 30—IF you lost your job, it won’t seem that safe.
You know that kind of reminds me of Dave Ramsey’s debt snowball technique in the sense that Dave admits the math doesn’t quite work out best, but based on the financial behavior of most people it is better to pay off the smallest debt first rather than the highest interest because it is a motivator that keeps people focused.
So for most people, the self imposed discipline of the 15 year note is preferable, because it is just too tempting to spend the extra couple of hundred bucks on consumption–rather than investment.
So perhaps this depends on your level of self discipline, as well. And it comes down to a personal assessment of how best will you stay discplined with your finances.
I think my wife would be better served with the 15 year note 😉
@ aspiration
In the context of investing instead of paying off your mortgage, inflation isn’t quite simply subtracted from the growth rate because if you are investing instead of paying of your mortgage, you get to pay the bank back with inflated dollars.
True…Dave has human behavior dialed in—-people always focus on the “finance” but never the “personal” part of it!
On the other hand, some people enjoy investing and saving. I guess if you get some emotional satisfication out of a penny saved is a penny earned, then maybe the 30 year note is the better choice.
True, but I’m guessing that’s 1 out of a 100 Americans. Seriously.
if we’re suggesting a set of best-practices here, I still feel the 15 is the no-brainer for those 99 other Americans.
Sorry eric, if you’re going to make up a statistic, as I often do, it needs to have some logical backing.
In my $200K example above, the 30 yr payment is ~ $1200/mo, $14,400/yr. If that buyer is using 25% of income, they are grossing $57,600. The difference to 15 yrs including the rate drop, is $435/mo or $5220/yr, nearly 10% of their gross pay.
If you were to look at the average budget, by percent, pie chart style, you’d find that even starting with that 25% mortgage, not too high, most people are not likely to have 10% available, and if they did, there are other choices, not for better return, per se, but other things. An emergency fund, decorating (let’s not kid ourselves what it costs to furnish a new house) etc.
The house, if not brand new, can have expensive repairs, and needing to use a charge card because the budget is too tight makes little sense. On the other hand from my own story, paying early is always an option when money frees up. If you said “more than half” I’d have not commented again. 99, sorry, no.
I would suggest that they should have done that math *before* they bought the house!—and $300-400/month while a lot is not the end of the world for most household budgets. Yes, if you have no other room in your budget to handle “life happening” it’s just a matter of time till something’s gotta give!
Sure 99% is too high, but even on this blog, I’d bet you the number is far over 50%. People rationalize their risk all the time and while they say they’re going to pay extra on the mortgage–they also say they’re going to use that gym membership all year too! ;]
eric – I am in an odd position.
I’d say that if people followed your advice, we would not be in the situation we are in right now. The self-destructing ARMs and subprime mortgages would not have existed if you had your way.
I do know that the median household income is $50K (2007 census). When you look at that number and combine it with the sorry state of savings, you’d have to see that the median family doesn’t have that extra 10% play in their budget (400/mo = 5K/yr = 10% of their income) and that if they did, it would take 5 years of saving it to achieve the recommended 6 mo emergency fund.
(But you are bright and will come back with, “Joe – that’s the problem, people are not budgeting right, whatever mortgage payment you agree to budget for JoeMedian, make that the payment on a 15 yr mortgage, and buy that house, that’s what he can afford.)
A brilliant insight, eric, and one I certainly can’t argue with, we just need a bit of a paradigm shift to get people to think that way and not overreach on their home buying decisions.
True that…if we can’t get that point across today, given the chaos/pain out there, boy..not sure we ever can!! Maybe the days of the McMansion are over?—-I do know that people will always think they can out-earn their stupid decisions!…that’s why I skew towards the conservative option. Good luck!….I know you’ll do fine because you’re paying attention. Readers of this kind of content…they’re not the issue!
Given today’s rates for me – 4.5% 30year fixed and 4.25% 15 fixed, I would still pick 4.5% to refi my current mortgage (no cost refi). After tax deduction, it is about 3.5% and over 30 years, 4.5% is not a hard number. And if you transfer your additional money to 401K and make investment, you should be fine – and I get Roth401K as well.
You can also get a tax deduction by giving to your favorite charity or church. Similarly the same tax deduction is applicable to the 15 year’s of interest too.
On a 100k note that’s about $50k more in interest paid over the life of it. And you mention “if” you did the ROTH—that’s one of the big issues. Most people say they’re going to invest with that extra money, but a lot of them just blow it and don’t invest it.
so you pay the $50k extra, and maybe do a ROTH—and owe the man for another 15 years!! $246/month more vs. 15 years of someone else having title on the place your kids sleep….no thanks.
also, the math on the ROTH—say you dumped the 15 years of house payment into a ROTH vs. the savings you mention on the 30. The 30 year plan would end up with more money in it, but subtract that $50k in extra interest paid and you’re back to par or below.
mostly this revolves around how disciplined you’re going to be. Everyone starts off with great intentions, but we all know how reality plays out. The 15 will pay off in 15 every single time. Good luck!
It is all about the discipline. Plus I think 4.5% is accurate for 30 years… I’m thinking 15 years are closer to 3.75% these days.
Every situation is different. If you can maintain the discipline then investing, in theory, should pay off over time. You have to maintain resolve and continue to invest when times get tough like the financial crisis in 2008. When stocks drop 33% will you keep investing? That’s the main driver.
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Kevin,
Just stumbled on your blog and this is a great discussion.
I am about to refi from a 30-yr 6% to a 15-yr <3.8% (TBD). I am in the military and one of the variables we've had add that others may not is that we will have to move several times within the 15-year period. So, we have to consider whether we will sell or rent out the house when we next move. It complicates the decision-making process. In the past, we've sold based on the idea that we didn't want any stress about tenants or house problems when we are 1,000+ miles away. This time (being close to retirement and facing about 2 more moves), we've decided to rent out the property.
Regardless of our sell/rent situations, I believe the calculations discussed above matter little in the final analysis of whether to go with a 15 or 30 yr. It's pretty clear that if you take the 30 and use the entire payment difference amount to pay down the 30 yr early, you arrive at a small difference between the number of months to pay it off. I look at those months as the cost of flexibility. The dollar amount differences are relatively small, too.
However, I look it this way – if we were to take the 30 yr mortgage and pay it down using the amount of the difference between the payments of the 15 yr and 30 yr mortgages ($250 for the sake of the discussion), AND a small crisis occurred (transmission breaks down, teenager learns to drive at the cost of the collision deductible, etc.), the temptation to use that $250 (times x months) to cover the crisis would be great. On the other hand, if we had the 15 yr mortgage and the same crisis, all other things being equal, we would HAVE TO find another option. That option might be to leave the cost on a credit card (we haven't carried a balance month-to-month in over 10 years) or it might be something else. In our mind, missing a mortgage payment would NOT BE AN OPTION. I am probably preaching to the choir, but you would be amazed at how innovative you can be when you establish certain things as not being options. For us, paying interest on a credit card is only minimally more of an option than defaulting on the mortgage. So, that means we may have to (perish the thought for most Americans) adjust our lifestyle downward…oh no!…you mean we can't have a movie channel on cable?…we can't go out to eat every week?…I can't have my daily $5 cup of coffee?… etc. (again, preaching to the choir).
I think it goes back to Eric's very early comment (eric_wan April 28, 2009 at 12:48 pm) about "heart" more than it goes math.
Finally, in 2002, we sold the previous house we owned (actually, the bank owned it, but they were nice enough to "rent" it to us) and that was the first time we were totally without debt. If you haven't experienced it, it's hard to describe how "unshackled" we felt when we no longer had the mortgage hanging over our head. Granted, we still had to rent or live on post (and give up housing pay), but we were free in our minds. Mentally, 30 years seems almost as though there is no end. Fifteen years doesn't seem that far off. And, if we pay extra on the 15 yr mortgage, whoo-hoo!, that would be an accomplishment for us.
Thank you all for the thought-provoking comments.
P.S. Slight tangent – Try having you and your spouse consider that divorce is never an option and you will be amazed at the problems that DON"T come up.
I am an immigrant and in the middle of hunting a house and mortgage. I read most of the posts here especially Eric’s. Now I have an answer for myself. If the banks could make the 15 as a “tradition” (BTW, who makes the tradition), the America builders will build more economy (smaller) houses to suit the demands. Therefore, the homeowners do not have to go to Macy’s, Best Buy or Home Depot to buy a lot things to fill up their huge closet, kitchen and garage. Then they can pay extra $400 to mortgage and another $400 to 401K and Americans can retire at 50 instead of 65!!!
House Hunter, you are spot on…it can be a virtuous circle for the buyer and generally speaking, the economy.
I think the bank’s came up with the 30 year concept—in conjunction with the mortgage bond market possibly? I don’t know the history on it, but it is an arbitrary number really.
The US suffers from stuff-itis—filling a hole in our lives with stuff. Reminds me of a gas—just fills whatever void it finds. Now we export it! ;]
@House Hunter & @eric_wan
The debate and usefulness of the 30 year mortgage could go back n’ forth depending on which team you play for.
Proponents of banking:
1) lowers barrier to entry/greater affordability
2) lowers risk to borrower and bank (lower payment means easier to make payments)
3) locked interest rate & future inflation benefit borrower (a $1000 mortgage payment started in 1996 is easier to make today than it was 15 years ago)
Critics of banking:
1) increases banks profits via amortization equation
2) easier to inflate housing prices
3) US government encourages & rewards indebted citizens (indebted citizenry never strikes; always works)
As with most things, there are lots of variables to consider and what might not benefit one person benefits the other.
I think your lists pretty much land on the side of encouraging the 15 year. Greater “affordability” is maybe not such a good thing? And while the inflation hedge via a fixed rate works for either term, I don’t equate 15 extra years of indebtedness to lower risk—for me that would be higher risk, but again that is just me.
Before the housing crisis, my friend reminded me to buy a more expensive house so the house could appreciate more faster. But now I don’t think I would listen to him. I decided to go for a house about $30k less value than my initial plan, therefore I could go for 15 and just add about another $200 which probably I could save from the gas and electricity from a bigger house. Thank you all of you for the posts. I learned a lot from different views.
@ eric_wan
Yes, my bias would side towards the 15 year since I’m against paying more in interest payments than need be.
But honestly, after working in finance for a few years and learning the “dark side” of the business, I’d suggest paying in cash or using owner financing.
Why allow banking middlemen to make the profits on the interest rate spread (your savings account at 0.XX% vs. mortgage rates at 4-6%) when you can keep it yourself?
yeah Matt…I hear you. I’d love to do the 100% down plan, but decided to roll the dice with the bank @ 15 years. I do know a guy who did that though—everyone thought he was nuts at the time.
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Hey Kevin,
I think your post is dead on. Two years ago we were exactly in this position: 30 or 15 years. We knew that for the foreseeable future we would be able to make 15 year payments but then again, if we paid of the 30 year mortgage making 15 year payments, the additional interest payment due to a slightly higher rate for the 30 year loan would amount to less than 2% of the whole paid sum.
Sure enough, two times we hit a rough spot since then where cash got really low and we were really glad to be able to cut down our payments. So yes, I can only recommend going for 30y mortgage, but paying it off in 15y 6mo or so (who says you can’t even pay it off faster 😉
Great discussion here. From my perspective, I basically agree with everything Eric (aka Dave Ramsey) says. Having a finance background I know so many co-workers and friends around me that think this is a weird way of thinking, but for me there is something so profound about the simple and straightforward (aka Dave Ramsey).
Everything comes down to risk. One’s ability to tolerate it that is. I may be weird, but I’m not willing to “leverage” my family’s future. I hate that word LEVERAGE.
Besides can’t everyone agree that we are always trying to contain risk. Saving for retirement, building up an HSA, owning a car free and clear, owning your home, and ultimately building wealth? For me those are the goals and I don’t think owing on a home for the next 3 decades can get me there.
still a great time to buy if you’re in a position too—record low rates (on 15 year notes!), lots of supply, lots of motivated sellers! Plus even though the recent track record isn’t great, over time quality real estate isn’t a bad investment—-inflation hedge, good tax benefits when you go to sell etc., good appreciation potential (over time).
Re/ your comment on containing risk—most people would agree with your logic (me too!), but culturally we have come to devalue cash (odd!) and value the ‘ability to borrow’—as if borrowing leads to financial strength? It seems more people are concerned with their FICO score than their savings balance—-the debt industry has done a FABULOUS job marketing their product…to the point that many people can’t even conceive of another way to live! We watch the political gyrations in DC about our debt, yet at home continue as if debt is smart and sophisticated. I tell my friends it ‘all starts at home’! ;]
this is what i did to lower my risk and take advantage of the low rates. About 3 years ago, i cashed out my property while the housing prices were still decent. I used this money to buy 2 distressed properties that i knew would give me positive cash flow. Within this time i have refinanced 2 times and currently going on my third. Each time i refinance for 30 year mortgage to keep my payments as low as possible. We have been making extra payments each month and also throw in extra money to reduce the loan principle. 3 years later i am glad to say that our cost which includes mortgage, property taxes, and insurance for all 3 residences will be only $400. And i am living in an expensive area, (orange county, CA) so this is possible for all of you who are thinking about cashing out your houses and investing in properties. Anyway, I am refinancing for a 30 year loan and i dont care if it takes another 30 year to pay it off, because my payment is so darn low anyway. By the way, 3 years ago with one house i was paying at least $1600 a month. To me it doesnt make sense to pay off the loan in 15 years if i can pay so little now. it is as if i had paid it off already and only have to pay taxes and insurance now.
So what if you don’t find renters? or they trash the place? You have no cash to carry you through both eventualities or maybe you do? Either way, you are taking on far more risk than you may think….what you’re doing is what all the ‘no money down’ cable infomercials advertise—taking on debt/risk against potential cash flow—HELOC’s for everybody! You could have also just paid off your primary residence, built up cash and bought rental #1…still just paying your taxes/insurance, but have far less risk.
I agree with eric_wan. I’m not sure how ann can manage, but it I were her, I would pay extra toward #1 mortgage first… Property investment is great, but having three mortgage seems super risky. Also depending on renters is more risky. My husband and I are thinking to pay our first place mortgage off in 5-8 years, then buy a investment property if it makes sense to us.
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