A 30-Year Mortgage Is Almost Always Better Than A 15-Year Mortgage
Here’s a simple scenario, you are purchasing a home and plan to take out a $250,000 mortgage to finance the purchase. Based on your income, you can easily make the monthly payments, so squeezing every dollar out of your monthly budget is not an issue. So, the question, do you want to continue payments for the next 15-years, or the next 30-years. I don’t know about you, but 15 years sounds a lot better to me. Once I’m done, I own the home, and no one can kick me out.
Here’s another way to look at it. A 15-year $250,000 mortgage today (2018) has an interest rate of 4%. That equates to a monthly principal and interest payment of $1,849. A 30-year $250,000 mortgage today has an interest rate of 4.5% and a monthly principal and interest payment of $1,267. $1,267 a month for 30 years is a total payment of $456,017 compared to $1,849 a month for only 15 years is $332,860. Do you want to pay the bank $456,017 or $332,860?
The above are the main reasons many home buyers choose a 15-year mortgage. I’m here to tell you, they are wrong.
A 30-year makes more sense based on present value
One of the most basic concepts in finance is the idea of present value. It’s simple, money today is worth more than money tomorrow. This is the “time” value of money. Think about this; if I offer to give you $100 now, or $100 a year from now which do you want? The answer; always take the money now. If, on the other hand, I offer to give you $100 now or $110 a year from now, you may choose to delay gratification, but do you know how to calculate whether you are getting a good deal? The calculation you would typically use is present value and I will leave the discussion on how to calculate present value for other articles on this blog.
For a mortgage, you are on the other end of the equation. You are not receiving money, you are giving money. So, ask yourself, you owe someone $100 – would you like to pay them now, or would you like to pay them 1 year from now? You may say, well, I want to get it over with, and that’s fine, but the rules of finance state that you should always pay later. Why? Think about what you could do with the money in the next year. What if you could invest it and make it grow to $110, pay off the $100 debt, and keep the $10?
Mortgage payments work the same way. In choosing a $1,267 payment for 30 years, or a $1,849 payment for 15 years, the rules of finance dictate that a lower payment is better. Ask yourself, what could you do with the $583 a month difference for the next 15 years? To prove the math, run the number through the Present Value formula. Here it is:
What you are doing here is calculating the value today of a stream of payments stretching out into the future, so you can properly compare one stream of payments to the other. As we discussed above, the 15-year mortgage totals $332,860 in payments and the 30-year mortgage totals $456,017 in payments, for a difference of $123,157. But that’s over decades. The annualized present value of the 30-year term is $247,600 compared to the 15-year term of $246,724. The 15-year term now has less that $1,000 advantage, based on time value of money. Are you willing to commit to higher monthly payments for the next 15 years for a lifetime advantage of less than $1,000?
What you are doing here is calculating the value today of a stream of payments stretching out into the future, so you can properly compare one stream of payments to the other. As we discussed above, the 15-year mortgage totals $332,860 in payments and the 30-year mortgage totals $456,017 in payments, for a difference of $123,157. But that’s over decades. The annualized present value of the 30-year term is $247,600 compared to the 15-year term of $246,724. The 15-year term now has less that $1,000 advantage, based on time value of money. Are you willing to commit to higher monthly payments for the next 15 years for a lifetime advantage of less than $1,000?
A 30-year makes more sense based on alternative investments
Present value calculations can be a little abstract making the concept hard to grasp, so I want to show it to you a different way. In deciding between a $1,267 payment for 30 years or a $1,849 payment for 15 years, ask yourself, what could you do with the $583 difference for the next 15 years?
Look at the chart above. The numbers have been annualized for simplicity. $583 a month is $6,990 a year. If you invested $6,990 a year at a reasonable 6% return, by the end of year 15, you would have $172,463. Your remaining balance on your 30-year mortgage would be $165,585. So, if you took the 30-year, invested the difference at 6%, you would be able to pay off the remaining mortgage balance, and still have a $6,878 left over.
But, forget about paying off the mortgage after year 15. If you were to start withdrawing the $1,267 a month from the investment account using it to make the next 15 years of payments and continue to invest the remaining balance at 6%, by the end of the 30-year mortgage, you would still have $38,281! As long as you are willing to invest the difference between the 15 and 30-year mortgages, and take the time to manage those investments, the 30-year is most likely going to be a better deal.
So, is there a catch? Yes.
There is no guarantee that you will achieve the 6% yield. That’s the risk. Of course, if you can make more, you’ll come out even better. At 8% investment return, the 30-year mortgage has a $204,483 advantage. At 10% which many stock brokers claim they can do over time, the advantage is $489,252 to the 30-year.
