What is the best mortgage selection?
What is the difference between a 15 year and a 30 year mortgage?
Individuals consistently ask themselves whether they should obtain a 15 year or 30 year mortgage and many people wonder what the impact of each is today and in the future.
The traditional example compares the interest paid in each scenario. The rational is very often that a 15 year mortgage is superior because you will pay less interest to the bank than you will with a 30 year mortgage.
The below shows this traditional comparisons between the 15 and 30 year mortgage.
30 year loan
360 payments, 4% interest
Monthly payment = $2,387
Total payments =$ 859,347
Interest payments = $359,347
15 year loan
180 payments, 4%interest
Monthly payment = $3,698
Total payments = $665,719
Interest payments = $165,719
Without any critical analysis and without changing the interest rates between the 2 loan options it seems obvious that the 15 year mortgage is the way to go. With the 15 year mortgage we will have substantial higher monthly payments but overall we will end up paying a lot less interest and after 15 years we do not have to worry about the monthly payments.
But let’s analyze it in more detail and take it a step further; let us assume that the 30 year mortgage borrower deposits the difference between the 30 and 15 year payments into a wealth building account
Monthly payment difference
$3,698 (15 year mortgage monthly payment)
-$2,387 (30 year mortgage monthly payments)
$1,301 (difference that can be deposited into wealth accumulation account)
If we just look at the next 15 years this means that the person with the 30 year mortgage can take$1,301 a month ($15,502 annually) and deposit into a wealth accumulation account. If we assume that this account can give us a net 4% rate of return over this 15 year period the account would grow to about $324,000and at that point in time the outstanding mortgage balance would be about $324,000 as well and assuming that there is no prepayment penalty the 30 year borrower could take the money from the wealth accumulation account and pay of the 30 year mortgage. With these numbers the outcome between the 15 and 30 year mortgage is the same. House is paid off after 15 years in both scenarios.
Practical issues to consider:
1. Deductible interest: The IRS still allows for mortgage interest deductions and therefor the 30 year mortgage might provide a more favorable situation in regards to itemizing deductions*
2. Lower risk: The risk of not being able to pay the monthly payment on the mortgage is much lower on the 30 year loan as the payments are greatly lower so in the event of job loss having the wealth accumulation account can help an individual get by.
3. Opportunity cost: The wealth accumulation account will always be available for financial opportunities that may arise in the future whereas equity in a house is more difficult to access.
So while the traditional argument for the 15 year over the 30 year option seems to make sense a more detailed analysis shows that many people might be better off taking on a 30 year mortgage as it creates much more flexibility.
There is one more thing that 30 year mortgages have compared to a 15 year and that is a typical higher interest rate. Even if we assume that the 30 year interest rate is higher than the 15 the wealth accumulation account will be large enough to pay off the mortgage much sooner than the original 30 years and even if there is small deficiency after 15 years it could be worth considering 30 years as it can create improved accessibility to wealth, flexibility and control of when to pay off the mortgage. The real issue when analyzing a 15 vs 30 year mortgage is what value an individual places on maintaining control of as much of one’s wealth and keeping a flexible plan in place. In either scenario the loan could be paid off after 15 years.