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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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.
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