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 versus 15-year mortgages comes in. There’s no right or wrong answer for which you should pick (we’ve talked about this before in a previous article). However, there may be some ways of looking at the choice that you haven’t thought about before.
Comparing the Numbers
Looking at the mortgage APR table that we have here at Dough Roller, you can see that 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 options. In this case, it’s $578. If you can manage the higher monthly mortgage payment, though, 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 0.644%.
- 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 will have shelled out $66,770 in interest. However, with the 30-year mortgage, you would have paid $175,533 in interest. That’s 263% more!
Based on this, the answer seems pretty clear-cut. If you can afford the increased payments, you would fare much better with a 15-year mortgage.
…or would you?
A Different Perspective
This isn’t the whole picture, of course. 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 $108,763. If your marginal rate is, say, 30% (federal + state), the real difference is about $76,134 after taxes ($108,763 x (1 – 0.3)).
That’s still a lot of money. But what if you kept the extra $578 a month by sticking with a 30-year mortgage term, and decided instead to invest it? This is the opportunity cost comparison.
Let’s say you invested the entire $578 each month (how disciplined of you!) into a low-cost index fund. Let’s also say that over 15 years, you averaged a 6% return each year (compounded).
At the end of 15 years, you’d have $171,129 in savings, made up of $104,040 of your deposits, and $67,089 of investment returns. You’d pay 15% capital gains on those returns. But this still leaves you with a very healthy $161,066 ($104,040 + $67,089 x (1 – 0.15)). Plus, you would also have paid $89,328 of your $250,000 mortgage principal, bringing the balance down to $160,672.
You’d have more than enough to pay off your mortgage balance completely!
If you averaged an 8% return a year (compounded), your savings would increase to $203,393, made up of the same $104,040 in deposits plus $99,353 in investment returns. That works out to be a very healthy $188,490 once you’ve paid the capital gains tax ($104,040 + ($99,353 x (1 – 0.15)).
You should note that in these calculations, I am ignoring all fees and assuming that the mortgage terms allow you to pay it off early. Not all lenders allow this without a prepayment penalty, though, so be sure to check with yours.
Resource: Find a great mortgage rate online in seconds at LendingTree.
Which Is Right for You?
So, why would you go to all the trouble of doing this? The answer is simple… flexibility.
Sure, you could stretch your finances a bit and pay off the note sooner. By taking out the 30-year mortgage, though, you have given yourself the flexibility that comes with lower payments. You now have the option to invest (or spend) anything left over every month.
You have the luxury of liquidity with that extra money each month: a choice between investing, spending, or prepaying your mortgage. With long-term stock market returns of 8%, assuming an average 6% return is reasonable (although nothing is guaranteed). Plus, it 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. However, you might instead use the money to clear out credit card debt, pay off school loans with rates above that of your mortgage, or take care of other high-interest debt.
All of these examples offer a better use of the money than paying down a low rate, tax-deductible mortgage.
Also, unless you have a significant amount of wiggle room in your budget, opting for a 30-year mortgage can offer your family an added sense of security. Think about if you were to choose a 15-year mortgage with just enough income to make the monthly payment work. What happens if you lose your job, suddenly have unforeseen expenses, etc.?
By choosing the lower monthly payment, you have given yourself a safety net. Sure, the smartest thing would be to invest that money monthly and watch it grow. If something comes up and you absolutely need to use the money elsewhere, though, you can. That security brings with it quite a bit of value.
Although you do pay more in interest (even after taxes) as a result of the 30-year mortgage’s higher rate, the outcome could be exactly the same if your investments pay off. You’ll still have a fully satisfied mortgage after 15 years but with the added potential for greater returns, depending on how your investments perform.