The 15-year vs. 30-year mortgage has been debated for a very long time. People like Dave Ramsey has said to not even have a mortgage and pay in cash, but if you must have a mortgage he is adamant about 15-year mortgages only. Still, others say that the 30-year mortgage makes the most sense.
So, before we begin to tackle this debate, let me give you my opinion on what you should consider before even contemplating a mortgage. You really should work towards having an emergency fund of 3 to 6 months of expenses saved. This will make a lot of sense when we dive into whether to have a 15 or 30-year mortgage. Also, plan on limiting your monthly payment to no more than 25% of your take home pay. Consider having a goal of being debt free when approaching retirement, which includes not having a mortgage.
Alright, first, let’s look at the differences between the 15 and the 30-year fixed mortgage.
A 15-year mortgage pays off the home quicker, builds equity quicker, has a lower interest rate and less overall interest payments. While a 30-year mortgage takes longer to pay off, more of the payment goes toward interest especially in the beginning, has a higher interest rate, and will pay more in interest payments.
So, when we look at the differences between these two, it seems that the 15-year mortgage would be better. Yet, according to Chris Hogan-- author of Everyday Millionaires-- 90% of people choose the 30-year mortgage.
Let’s take a look at a mortgage calculator from bankrate.com for a real life example.
Let’s say you are in your 30’s with a household income of $80,000 a year that is take home pay. Let’s also assume you are looking for a home that is $300,000 and plan on putting down 20% as a down payment. This would mean your loan is going to be $240,000. With an assumed interest rate of 3% on a 15-year mortgage, the total payment would be $1,936 including taxes and insurance.
Uh-oh! Remember when I said to try to have your payments no more than 25% of take home pay? Well, 25% of take home pay, in this example, would mean that monthly payments should be no more than $1,667.
So, if you wanted a 15-year mortgage you would need to adjust your purchase price of your home and may not qualify for that $300,000 home. By looking for a lower-priced home-- say, $250,000 in this example-- then your payments would be in line with 25% of take home pay at $1,661 per month. Although, this might mean that looking at a cheaper priced house could force you to look outside the area where you want to live.
However, if we changed this to a 30 year mortgage on the $300,000 home and an assumed rate of 3.5%, look what happens to that monthly payment. It is now $1,356 per month and in line with 25% of take home pay.
So, one advantage we see here with the 30-year mortgage is that it gives you more purchasing power and flexibility.
Now, let’s look at another scenario.
What if your income was higher and you could afford the 15-year mortgage, but still went with the 30-year mortgage with the idea of investing that difference? Let’s see how that would work.
So, you could invest the difference of $580 a month in an investment account (and let’s just assume it earns 7% per year in that investment account). A simple online investment calculator reveals that in 14 years it would be worth $161,925.41 and then you could turn around and pay off the remaining balance of the mortgage and thus paying it off in 14 years.
However, there is a lot wrong with this example. Number 1: we are assuming a 7% hypothetical rate of return every year, which most likely will not happen. Investments carry risk and they can go up or down and there is even a risk of losing principle. Number 2: the example doesn't mention taxes. Investments can carry a tax burden depending on how it’s invested. It could be capital gains tax, tax on dividends, and tax on interest. This would make your net gain smaller. It would also take discipline to invest that $580 per month, every single month. If you could do that, then you may as well just take the 15-year mortgage.
Now, you could treat your 30-year mortgage like a 15-year mortgage by paying extra each month. If you took that same difference of $580 and made extra payments each month, it would be paid off in roughly 15 years. However, you still would have paid more in interest. But this would give you some flexibility when times are tough or maybe a loss of your job. You wouldn’t be strapped with that higher 15-year mortgage monthly payment. This is why I stress having an emergency fund in these situations.
So, sometimes a 30-year mortgage may make sense. I would say if you are in your 20’s or 30’s and maybe starting a family, cash flow is very important. You may have student loans, child care costs, and other expenses. By having that lower payment, this could give you some breathing room. When things change and income increases, then you could throw more money at that mortgage to pay it off quicker. Some people do not have predictable incomes, maybe you are in a sales position and earning a commission. Having the flexibility of the lower payment on the 30-year mortgage could help you get by in the lean months.
When you are in your 40’s and 50’s, this is considered the peak earning years so perhaps consider the 15 year mortgage.
Now there are other things to consider such as inflation, taxes, interest rates, and home prices in your region.
Also, you may want to consider lowering your standards on the home price to get that payment more reasonable.
The bottom line: consider having a goal of paying the home off as quickly as possible and certainly before retirement.
Keith Wilson, CLTC
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
This information is not intended to be a substitute for specific individualized tax advice. Please seek a professional tax advisor.
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