You can always tell when interest rates have dropped. Your Facebook feed suddenly gets overrun by Quicken Loans adds promising to save you thousands of dollars in interest if you switch to a 15-year mortgage. It seems too good to be true, so is it?
It is true. A 15-year mortgage will drastically lower the total interest you will pay over the life of your loan. By putting more money toward your principal each year, you reduce the balance so quickly that your interest cost drops much quicker than if you were in a 30-year mortgage.
Not only do you pay the principal down quicker, but you also save on 15-years of interest payments. Even though your interest paid decreases each year, the last 15 years of interest still packs a punch. For example, in a 30-year 3.25% mortgage for $200,000, year 16 still has you paying about $320 per month in interest. The interest is less than the first years, roughly $535 per month but still substantial.
The savings can be so substantial that paying the same $200,000 mortgage off n a 15-year schedule would save you about $60,000. So that settles it. The 15-year mortgage is the best option.
Except, When It’s Not
You remember the old saying, “figures don’t lie, but liars figure?” This is one of those examples. Quicken Loans, and other lenders, are not lying; a 15-year mortgage is a great way to save on interest. What they are not telling you are the different costs involved—namely, opportunity cost.
Opportunity cost is one of the most essential and forgotten economic concepts. Opportunity cost is what you lose out on when you use your resources. In Basic Economics, Dr. Thomas Sowell uses dairy farmers’ example of selling milk to ice cream producers. When the ice cream producer buys the milk, a yogurt producer cannot. In this instance, the opportunity cost of making ice cream is less yogurt.
When making a mortgage decision, the opportunity cost of a 15-year mortgage is everything you could have used your money. In the above $200,000 mortgage, the payment difference would be about $600. When you go to a 15-year mortgage, you can no longer use that $600 to buy a new car. You’ve given up the opportunity to buy a new car.
If your decision is between a 15-year mortgage and a new car, please choose the 15-year mortgage. On the contrary, if your decision is between a 15-year mortgage or funding your retirement, you may choose to fund your retirement. If the extra $600 per month would allow you to invest more, your young, and you plan on being in the house for many years to come, you should heavily lean in this direction.
Things to Be Careful With
Before I go any further, I want to stress a few things first. These are significant factors and may lead you to be in a 15-year mortgage.
First, I am assuming you will stay in this loan for the next 30 years. With interest rates as low as they are, you probably will not refinance your mortgage again, but if you plan to move or sell the home in the next ten years, you should lean toward a 15-year mortgage. Without giving your investments enough time to level out the up and down swings, you are taking too much market risk to use this technique for less than ten years.
Likewise, if you are within fifteen years of retiring, you should heavily lean toward a 15-year mortgage. Being mortgage-free at retirement is one thing I stress as much as possible. Carrying a mortgage payment into retirement can be a significant stress on your investments and immense stress in your life.
Third, you must have discipline. You cannot take this approach and “forget” to set up the investments. You cannot decide to take a month off because money is tight. You have to follow it through. If you are not disciplined and spend the $600 per month, you are better off with a 15-year mortgage. One of the nice things about a 15-year mortgage is its ability to function as a forced savings account. As you build equity, you are essentially saving money for the future.
Fourth, don’t get a 30-year mortgage so that you can buy a bigger and nicer house. Again, don’t let your realtor or mortgage office convince you to buy a bigger, nicer, more expensive home. One last time, just for good measure. DO NOT BUY A BIGGER HOUSE!!! Instead, buy a house you can afford on a 15-year mortgage but use a 30-year mortgage and invest the rest.
These four warnings are just a few of the aspects used when deciding between a 15-year and 30-year mortgage. If you meet these three criteria, you can move on.
Now, Let’s Look at the Benefits
1. Cash on hand
One of the significant benefits of the 30-year mortgage with investments is your immediate access to cash. If you have a real emergency, you can always take the money out of your investment account. The key is to define what is an emergency. I define an emergency as prolonged unemployment or major illness. Something that takes a substantial amount of resources to get through, and no other options are available.
A car breaking down is not an emergency on this level. Likewise, college costs are not am emergency. Most home repairs wouldn’t even constitute an emergency worthy of taking money from the investment account.
2. You will accumulate equity faster.
Your investment account will grow bigger and faster than the equity of your home. For example, if you earn 8% in your investment account, you will have enough money to pay off your mortgage in month 152. That is 28 months ( two years and four months) earlier than a 15-year mortgage.
Even if you earn as little as 4%, you’ll be able to pay the mortgage off about five months early.
3. You Will End With More to Retire On
Interest rates are at an all-time low. If you take advantage of this opportunity, you can have a substantially larger nest egg when retiring. You will end up with about $790,000 in your investment account.
The question you should ask is, “what If I took out the 15-year mortgage and in year 16 started investing the entire monthly payment? What would I end up with?” That is a great question, and if you asked it, you have learned the concept of opportunity cost. The answer, $490,000. The difference is about $300,000.
For many of my clients, I recommend a longer mortgage partnered with an investment account. If done right and disciplined, it can lead to a level of freedom and flexibility that a 15-year mortgage will not allow. It’s not suitable for everyone, and lately, I’ve been making more 15-year mortgage recommendations, but if it is right for you, it can be a compelling strategy.
If you’d like help with a mortgage review, please reach out to me or schedule a time to speak.
There are a few more complex reasons this system works. There is also one assumption I made that I want to explain. Let’s start with the assumption.
I am assuming an 8% rate of return over the 30 years. This rate of return should be pretty reasonable for the following reasons. First, you have a 30-year time horizon, so you can afford to invest this in growth or even aggressive growth portfolio (not individual stocks) using mutual funds or ETF’s. A good example is the Vanguard LifeStrategy Growth Fund that has returned about 7.85% since 1994, or if you are a little more aggressive, the Vanguard S&P 500 Index has averaged 10.94% since 1976. Please do more research to decide which fund is right for you.
Taxes are another reason this strategy may work well. You should not carry a mortgage just for the tax break, but if you qualify for the mortgage interest deduction (most people do not), your actual interest cost per year will be less than the interest you pay.
Lastly, this example ignores inflation. Inflation is simply the increase in the money supply that leads to increases in prices. In its simplest terms, milk will cost more in 5 years than it does today because your dollar will be less valuable. With current government policies endorsed by both parties, it’s hard to argue that we will not see moderately high inflation levels in the coming years. Inflation makes your future mortgage payments cheaper than today. Meaning the more we push dollars into the future, the cheaper the actual mortgage is.