The Money Mustache Community
Learning, Sharing, and Teaching => Ask a Mustachian => Topic started by: onemorebike on January 23, 2013, 04:18:26 PM

Just got through reading one of MMM's older blogs on the 15 versus 30 year mortgage. His take was that it was wasteful to do a 30 year because of the amount of interest paid over the life of the loan, which makes sense. I tried to calculate this for my two properties, to get an idea what we could be doing better and realized I would be putting more toward principal but the interest was almost the same (month to month). Is the thought just that you don't pay interest for an additional 15 years?
This seems like it should be a good idea (probably for rental and for my residence), I think I just need some help understanding the math.
Appreciate any feedback.

If you prioritize liquidity for investments that could theoretically return above 45% (and hopefully much more), then do a thirty year note.
If you prefer less debt, value a paid off home (although there's always taxes), and a secure 4% return on your money, 15 years is probably more up your alley.
I'm the second guy myself.

Is the thought just that you don't pay interest for an additional 15 years?
Yep.
You're also paying a higher percentage of your income to retire the mortgage. The difference in the size of the payments jumps up quickly for balances above $100K.

Most mortgages have no prepayment penalty. A 30 year can be viewed as a "maximum of 30 years" loan which you intend to pay off in 20 years or so. It's just that you have the ability to resume to the "minimum" payments during a cash shortfall.
That said, I still like getting a 15 or 20 for the lower interest rate.

Yes, it is the interest not paid during the second 15 year stretch that saves the most money, but usually there is also a decent drop down in interest rates by going with with a 15 year mortgage. If there was no drop in interest rate you could just take the 30 year and double the payment each month, which would save the same amount of money while keeping your options open. A 15 year mortgage can also provide the incentive some might need to pay off the house more quickly, because a mortgage payment is absolute while simply paying it off faster can be hard to keep at without strong internal discipline.
At the current low rates it just becomes a matter of personal preference based on risk tolerance, balance of investments, desire for investment growth, etc.

I got a 30 on my current residence. I wasn't sure how long I would stay, and the lenders were beginning to tighten up credit at the start of the collapse. I figured my application would "look better" to apply for a lower monthly.
True, I have not made any extra payments. But I'm also glad I had the mortgage set where it was, because unforeseen expenses did crop up during the last few years and covering all my bills got tight for a while.
I have made additional payments on unsecured debt though, and almost eliminated that. I'd like to start whacking at the mortgage itself next year.
There is a 15 year on one of my rentals that's about half paid off. It does feel good to look at the monthly statements now and see real progress taking place!

One of the things I feel isn't addressed when discussing 15 vs 30 year is inflation. When you have a 30 year, inflation is working in your favor, assuming you're in an industry where wages aren't stagnant and are at least moving with inflation. When you've got a 15 year, the second 15 year period your (generously) 67% gains get a 24% whack taken out of them because of inflation. I could be way off base here, and I'd love to know if I'm thinking about this the wrong way.

Most mortgages have no prepayment penalty. A 30 year can be viewed as a "maximum of 30 years" loan which you intend to pay off in 20 years or so. It's just that you have the ability to resume to the "minimum" payments during a cash shortfall.
This is the way we did our mortgage . . . kinda a safety thing.
We are paying off our mortgage at about the rate of an 8 year mortgage due to all the prepayments, but in case of financial trouble or whatever we can stop doing the additional payments and drop down to the 30 year rate (much lower monthly costs). Seemed like a good idea to me when we signed up, still does four years later.

If there was no drop in interest rate you could just take the 30 year and double the payment each month, which would save the same amount of money while keeping your options open.
Slight correction: you don't need to double the payment to pay off a mortgage in 15 years vs. 30 years. For example, for a $200k loan at 4%, the monthly payment for 30year amortization is $955, while it's "only" $524 more (total of $1,479) for 15year amortization. This is also just the principal+interest; when most people think of their "mortgage payment", it also includes taxes and insurance, and since those stay constant regardless of the amortization period, the differential between the two payments will be even smaller than that. I mention this just so the OP doesn't think "oh crap, going to a 15year DOUBLES the monthly payment?!"
We are paying off our mortgage at about the rate of an 8 year mortgage due to all the prepayments, but in case of financial trouble or whatever we can stop doing the additional payments and drop down to the 30 year rate (much lower monthly costs). Seemed like a good idea to me when we signed up, still does four years later.
Yep, I did the same (well, payed my 30year mortgage at a 15year rate) and it seemed like a good idea when I signed up, and continued to seem like a good idea for 9 years, except then I went and paid the whole thing off, at which point I said "gaah, I should have gotten the lower interest rate that came with a *real* 15year (or even 10year) mortgage!" Ah, hindsight. :)

If there was no drop in interest rate you could just take the 30 year and double the payment each month, which would save the same amount of money while keeping your options open.
Slight correction: you don't need to double the payment to pay off a mortgage in 15 years vs. 30 years. For example, for a $200k loan at 4%, the monthly payment for 30year amortization is $955, while it's "only" $524 more (total of $1,479) for 15year amortization. This is also just the principal+interest; when most people think of their "mortgage payment", it also includes taxes and insurance, and since those stay constant regardless of the amortization period, the differential between the two payments will be even smaller than that. I mention this just so the OP doesn't think "oh crap, going to a 15year DOUBLES the monthly payment?!"
Good points.

I agree with smedleyb  much of this will come down to your risk tolerance, personality, family needs (i.e. property size), etc. However, if the 15year payment is doable and comfortable in the context of your overall budget, I would definitely suggest it. (So I would not suggest it if the payment throws your budget uncomfortably out of balance .. i.e. no room to save or invest.) In the part of the US where I live, standalone homes are a touch too expensive, so I purchased a town home in the fall with a 15yr at 2.5% fixed (no rate buydown), which was an overall amount where I could still save and invest. The amount of total interest paid in that case versus a 30yr at 3.5% is significant. In my opinion, if you want to pay it off in 15 years, then don't do the "I'll get a 30yr but plan to pay down more quickly" option, because you are committed to a higher rate, and, really, are you going to pay more if you don't have to? If you have liquidity concerns, I'd suggest that in a few years with a 15yr you'll have significant equity and could have a monster HELOC to fall back on. Depending on the range of cost of properties in your area, after 57 years with a 15yr, you could possibly even use that equity (via a HELOC) to purchase a rental, when you would likely not have been able to generate that same amount during that timespan with a 30yr.

My Tax professor did a research study where she compared what happened when a person took a 30 year mortgage and saved/invested the difference between the 15 year and 30 year. After the first 15 years the amount saved + investment growth and continued investment growth over the 2nd 15 years was enough to service the loan without additional cash.
I am in the process of refinancing the Home Equity Installment Loan our townhouse. I have to choose between a 18 year at 3% ($900/mo) or 30 year at 3.6% ($682/mo). If I save the difference $218/mo by my calculations I will need a measly annualized 4% return over the 30 year period to service the remaining 12 years after the first 18 years of saving. Anything over 4% would be extra for the stache.
From a liquidity factor I would rather have the $218/mo in a brokerage account. Additionally, my wife and I are not planning to stay in the townhouse for 18 years let alone 30. Likely, we will stay here another 35 depending on children. Potentially, could rent the townhouse once we move, but at a value of $225K (or more) I think the funds could be better invested in either equities or a different rental property.
At the end of the day I know it is a personal choice....but it seems like if I cannot generate 4% annualized return (in say VTSAX) then there are bigger problems. Although, if you don't like leverage then you would probably choose the shorter term.

Just got through reading one of MMM's older blogs on the 15 versus 30 year mortgage. His take was that it was wasteful to do a 30 year because of the amount of interest paid over the life of the loan, which makes sense.
I think he totally underestimates the impact of inflation, and the fact that inflation will make most of those payments for you by decreasing the amount of your mortgage in real dollars.
By paying "more" interest at today's low rates, you should come out way ahead in terms of real dollars, even sticking the money into something lowyield, let alone investing it in something with good returns.
but it seems like if I cannot generate 4% annualized return (in say VTSAX) then there are bigger problems
Absolutely.

Good points on inflation. We went with a 15 year at 2.75% (2.76% APR) that we will pay off in about 34 years or less. From a safety perspective, owning your own house is a very safe investment. No investment returns are needed to service a debt that does not exist. We do not plan on moving except into an urn at some point. In theory the value of the house may go up at approximately the same rate as inflation. Whether that happens or not, idngaf as our small sliver of paradise will be paid off. Leaving returns on the table in this case does not really concern me much as we love the set up we have. Not like, Love! Having your own crib payed off is a cornerstone of the MMM way of life I think, but in this as in all things, to each his own.

By paying "more" interest at today's low rates, you should come out way ahead in terms of real dollars, even sticking the money into something lowyield, let alone investing it in something with good returns.
It's the reverse of the Trinity Study. If you can get a 30year mortgage below 4% and invest it in the markets, then 95% of the time you'll "win".
A 15year mortgage is much more at risk to the sequence of returns. It's probably more than double the risk, but I've never bothered to run the simulation.

Anyone run the numbers on the interest paid on the 15 over 15 years vs the 30 paid off in 15 years where the 30 was paid off in a lump payment at the end of the 15th year?
I assume that would be the worst interest case scenario. Anything paid off sooner than that would only reduce the nominal interest paid over the life of the loan.
Mirite?

Assuming $200,000 mortgage, with 1% interest spread.
15 years at 2.75%
$1,354 per month x 12 x 15 = $243,720
30 years at 3.75% paid off in 15 years with lump sum at end
$919.10 per month x 12 x 15 = $165,438 + 120,472.34 = $285,910.34
Difference in favour of 15 year mortgage is a guaranteed $42,190.34
Now the fun stuff. If you do the 30 year route, and invested the lower monthly payment, what could the difference be?
$1,354  $919.10 = $434.9 per month to invest.
At 5% per annum return gives a total of: $115,172 less the $120,472.34 you need to settle the loan = $5,300.34
At 6% per annum return gives a total of: $124,778 less the $120,472.34 you need to settle the loan = $4,305.66
At 7% per annum return gives a total of: $135,299 less the $120,472.34 you need to settle the loan = $14,826.66
So there you have it. I will let you draw your own conclusion on what a realistic after tax and fees return you can get on you investments and how that will effect if a 30 year or 15 year term is better for you.
I know if I was in such a situation I would take the 15 year term.

Are you working at all during those extra years?
Because again you fail to account for i n f l a t i o n.
And why are you paying off a lump sum after 15 years? Run the numbers holding it to term for 30 years, and you may come to a very different conclusion.
FIRECalc makes it easy to run the numbers versus history, and it basically says youd'd have come out ahead investing the money over a 4% mortgage rate every time. Is it really different this time?

Assuming $200,000 mortgage, with 1% interest spread...
That is a bigger spread than is realistic IMO, but I think the important thing is that you wouldn't pay of the last 15 years of the mortgage in a lump sum. I ran the numbers for how much cash you would have in a savings account investing the difference every month for 30 years, or investing the full amount beginning 15 years in.
$200,000
15yr@2.75% = $1357.24/month
30yr@3.75% = $926.23/month
Difference = $431.01/month
Invest $431.01/month for 30 years. Compare that to Investing $1357.24/month for
15 years. Compare the end value with different rates of return.
30 yr total  15 yr total = difference
4%: $299,142  $334,003 = ($34,861)
5%: $358,711  $362,775 = ($4,064)
6%: $432,956  $394,710 = $38,246
7%: $525,819  $430,193 = $95,626
8%: $642,359  $469,656 = $172,703
9%: $789,068  $513,587 = $275,481
@7%, MMM assumption, that averages to $265.62/month for 30 years.
So the 15year wins if your rate of return is 5% or less. However, we are talking about a 30 year average. Since the historical rate of return over the last century has been around 10%/year, I'll take that bet.

My original mortgage was @ 4.875%. $1331/mo 30 yr. fixed. I was adding additional principle to pay it off early.
My new refi'd mortgage is @ 3.25%. $1040/mo 30 yr. fixed.
I have reappropriated the savings to investments that generate income. Instead of paying it off early I'm going to buy income generating assets to eventually offset and pay the mortgage for me. Once the mortgage is paid off I get to keep the house and the income generating equities. This calculation does not consider risk.
The decision was somewhat difficult for me b/c I really don't like having a house payment, but in the end the economics of letting cheap debt depreciate with inflation was just too tempting. I don't plan to let the house ride for 30 years anyways.

And why are you paying off a lump sum after 15 years? Run the numbers holding it to term for 30 years, and you may come to a very different conclusion.
Because that was the question that was asked.
"Anyone run the numbers on the interest paid on the 15 over 15 years vs the 30 paid off in 15 years where the 30 was paid off in a lump payment at the end of the 15th year?
"

I realize that.
The question was hypothetical, as in "why are you doing that?"
But your math did help show it's inferior to just getting the 30year mortgage and holding to term. :)

Apparently the 'average investor' has only made 2.1% over the past 20 years, LOL
http://www.businessinsider.com/chartaverageinvestorreturns201212

And, to post the more relevant statistic from that article, stocks over the last 20 years were up 7.8% (they cite 19922011, and since 2012 had great gains, that would likely be even higher, depending on how '93 was).
Still edging out gold and bonds, both of which had a nice run in there.
Whee!

Apparently the 'average investor' has only made 2.1% over the past 20 years, LOL
http://www.businessinsider.com/chartaverageinvestorreturns201212
Don't make dumbass "average investor" mistakes, and you'll outperform them. What's the significance of that statistic for a Mustachian?

To make sure we're all not 'average investors' I suppose!

You have to be honest about how long you are going to own the home too. I've read stats (can't find them now) saying that the average mortgage lasts seven years! If you are keeping the home forever, why not lock in a great rate for 30years? You can always refinance if rates go down. But if you are just going to sell within 5 years, maybe an adjustable rate is best.