If you’re like me, your Facebook feed is full of advertisements to switch from a 30-year to a 15-year mortgage. They tout incredibly massive savings. Is it legit?
Yes. Well, mostly. The savings on a 15-year mortgage is massive. For example, on a $150,000 4% mortgage the savings is $58,088. That is a crazy amount of money to save.
One of the most important economic terms you should know is opportunity cost. Opportunity cost is what you give up when making a decision. In this case, the opportunity cost of a 15-year mortgage is everything you can do with $393.14 per month; the difference between the much larger 15-year mortgage payment and the 30-year payment.
Most people that choose a 30-year mortgage use the savings to buy a car or go on vacation. If this is what you would do, please choose a 15-year mortgage. But what if you were to invest that $393.14 and earn 6% per year?
In year 5, you would have 27,440.84. That is a nice emergency fund.
In year 10, you would have $64,162.87
In year 15 you would have $113,305.23.
In year 30, your account would be $384,847.
Interestingly, in year 15, you would have a loan balance of $96,814. You could cash in your investments and pay off your mortgage and be about $17,000 ahead.
ONE MORE SCENARIO
To push the idea of opportunity cost, what if you did go with a 15-year mortgage and then starting in year 16 invested the full payment? Well in year 30 you would have $319, 886.
So the 15-year mortgage is more expensive.
SO WHAT SHOULD YOU DO?
Weigh your options. Before deciding between a 15-year and 30-year mortgage, there are a few questions you should answer. Here are the ones I always ask my clients.
1. When do we want to retire?
If you’re within 15 years of retirement, go with the shorter mortgage. A paid-off house is a must when you enter retirement.
If you are 15-20 years from retirement, you could go either way but if you are more than 20 years from retirement a 30-year mortgage with investing the difference is a great head start on your retirement account. Getting a compound interest in your favor is incredible!
2. How long do we plan on staying here?
If you plan on moving shortly, a 15-year mortgage is also a good idea. The extra equity will translate into a larger downpayment for your next purchase. It will also see more steady market volatility than investing in the market.
3. Do you currently have a fully-funded emergency fund?
If you do not have an adequate amount of savings, building a liquid emergency fund should be your priority. Equity is nice, but if you lose your job, no bank will give you an equity line. Besides them not wanting to lend to someone unemployed, do you want to borrow your way through an emergency?
4. Can I afford the 15-year payment?
I know what you are expecting. If the answer is no, then do a 30-year mortgage. But the real solution is blunter. If you cannot afford the 15-year mortgage, do not buy the house no matter what mortgage option you choose.
If you cannot afford the 15-year mortgage, you cannot afford the house. Do not buy it.
5. Will I really be disciplined enough to save the difference?
You have to take a good look at your level of discipline. If you do not believe you will be able to put away the difference into a long term savings account, don’t do the 30-year mortgage. The larger payment and quick accumulation of equity will act as a forced savings plan.
Honestly, there is no shame in this. Many people would be much better off taking the 15-year mortgage and building the equity if for no other reason than their inability to put the difference in payments into savings.
The decision between a 15-year and 30-year mortgage is highly personal. Typically it is much better to go with the shorter 15-year, but right now interest rates are so low taking advantage of the higher expected returns of an investment portfolio makes it a great thing to examine.