Taking out a mortgage is one of the biggest financial commitments you’ll ever make. It gives you the means to own your own home, but it’s also a decision you have to stick with for years. Some people call it “good” debt because it could increase your net worth. That said, it’s still debt, which means you’re paying interest in order to use that money. Financially — and to some degree, psychologically — it can sometimes make sense to pay this debt off quickly.
This is where the debate over 30-year or 15-year mortgages comes in. There’s no right or wrong answer for which you should pick (we’ve covered this further here). But there may be some ways of looking at the choice that you haven’t thought about before.
Comparing the numbers
Looking at the mortgage rates table here at Dough Roller, TD Bank is currently offering the following rates for a $250,000, fixed rate mortgage:
|Amount||Time Period||Mortgage Rate||Monthly Payment||Annual Payment||Total Interest|
Obviously, there’s a substantial difference in the monthly payment; in this case, it’s $568. If you can manage the higher monthly mortgage payment, you will save money for two different, but equally important, reasons:
- Lower interest rate: Banks typically charge a lower interest rate for the shorter term loan. In this case, it’s a difference of 0.75%.
- Shorter time period: Paying interest over fifteen years is half the amount of time, so you’ll make half the number of payments and pay a lot less in interest.
After 15 years of paying off a 15-year mortgage, you’ll have shelled out $60,762 in interest. However, with the 30-year mortgage, you would have paid $166,804. That’s 274% more! Based on this, the answer seems pretty clear-cut: if you can afford the increased payments, you should fare better with a 15-year mortgage.
Or would you?
A different perspective
This isn’t the whole picture, of course, because it misses a couple of key factors, such as taxes and opportunity costs.
You will generally get a tax deduction equal to your marginal tax rate times the mortgage interest you pay. For example, a comparison of the 15-year and 30-year options above shows a difference in total interest paid of about $106,042. If your marginal rate is, say, 30% (federal + state), the real difference is about $74,229 after taxes ($106,042 x (1 – 0.3)).
That’s still a lot of money. But what if you kept the extra $568 a month by sticking with the 30-year term, and decided instead to invest it? This is the opportunity cost comparison. Let’s say you invested the entire $568 each month (how disciplined of you!) into a low-cost index fund, and over 15 years you averaged a 6% return a year (compounded).
At the end of 15 years, you’d have $165,185 in savings, made up of $102,240 of your deposits, and $62,945 of investment returns. You’d pay 15% capital gains on those returns, but it still leaves you with a very healthy $155,743 ($102,240 + $62,945 x (1 – 0.15)). Plus, you would also have paid $90,793 of your $250,000 mortgage, bringing it down to $159,207. You’d almost have enough to pay off your mortgage completely.
If you averaged an 8% return a year (compounded), your savings would increase to $196,550, made up of the same $102,240 in deposits plus $94,310 in investment returns. That works out to be a very healthy $182,403 once you’ve paid the capital gains tax ($102,240 + ($94,310 x (1 – 0.15)).
(Note, I am ignoring all fees and assuming that the mortgage terms allow you to pay it off early – not all do without a prepayment penalty, so be sure to check with your lender.)
Resource: Find a great mortgage rate online in seconds at LendingTree.
What’s right for you?
Why would you do this? Flexibility. By taking out the 30-year mortgage — even though you could stretch yourself and your finances to pay it off sooner — you have the flexibility that comes with the lower payments, and the option to invest (or spend) anything left over every month.
You have the luxury of liquidity: a choice between investing, spending, or prepaying your mortgage. With long term stock market returns of 8%, a 6% return is reasonable (although nothing is guaranteed), and has the potential to be more.
In our example above we focused on investing the extra money you’d have each month with a 30-year mortgage. You might instead use the money to pay down high interest credit card debt, school loans with rates higher than your mortgage, or other high interest debt. All of these examples offer a better use of the money than paying down a low rate, tax deductible mortgage.
Although you do pay more in interest (even after tax) as a result of the 30-year mortgage’s higher rate, the outcome could be exactly the same if your investment pays off: a fully satisfied mortgage after 15 years, with the potential for greater returns depending on how your investments perform.