Last we week, my wife and I agreed to buy a house. From a financial perspective one of the biggest questions when buying a house is, “What do we do about a mortgage?” Most people who haven’t bought a home, don’t know much about mortgages. It’s not the kind of thing they teach you in high school. Of course this lead to a problem a few years back of people getting into mortgages that they couldn’t afford. I’m going to take a risk that most of the readers here have a basic understanding of mortgages.

So when I asked myself the question of what am I going to do about getting a mortgage, I thought the answer was going to be easy. Turns out it is a little more tricky than I thought. The first course of action was to decide between a fixed mortgage and an adjustable mortgage. I didn’t even spend 0.00002 miliseconds thinking about an adjustable mortage. With the interest rates nowadays it doesn’t seem to make much sense to risk that they’ll go up in the future. I called several lenders in the local area of the house and looked on the internet to get an idea of what rates we could expect. To get an idea, the lenders ask you are few questions… mostly about your income, debts, and credit history.

My wife thanked me for insisting that we keep track of our net worth every couple of months. It made answering these questions every easy. In addition the ability to get free credit scores came in handy as well. After providing that information to several lenders, each one came back with just about the same rates: 4.5% for a 30-year fixed, 3.75% for a 15-year fixed.

This is where I’m a little perplexed. We have the income for the payments either way. We also have a healthy emergency fund that can carry us through over 18 months either way. With that out of the way, it seems like it comes down to paying 4.5% vs. 3.75% in interest. It is better to pay 3.75% in interest, right? Well, I’m not so sure. There’s the opportunity cost to consider. If we were to go with the 30-year fixed mortgage, I would have more money each month to invest. Is that investment more likely to grow faster than the interest that I’m paying? It seems like history tells us it would. However, a lot of my investments in the last ten years haven’t grown as history has suggested it would.

One lender had a calculator tool to do a little math. He did the math on how much interest we’d pay over the life of the loan under a few scenarios. In the case of the 15-year fixed at 3.75%, we’d pay around $99,000 in interest. If we did the 30-year fixed at 4.5%, but made the same payments as the 15-year fixed requires in an effort to pay it off early, we’d pay around $130,000 in interest. Finally under the scenario of doing the 30-year fixed and making all the minimum payments, we’d pay around $263,000 in interest. I found a similar calculator at Bankrate.com.

These scenarios greatly make me lean towards getting the 15-year fixed at 3.75%. However, the opportunity cost of investing would likely mathematically mean otherwise.

Readers, here is where you come in. What would you do?

DC_Man says

30-year fixed at 4.5%, but made the same payments as the 15-year fixed…

This gives you the most flexibility to pay it off early, but have the option to drop it down to the minimum payment if you lose your jobs, etc…

Plus, you do have the opportunity cost issue.

Rob says

Normally I recommend the longer mortgage. Lower payments give you some extra flexibility, which is a great thing to have. However, since you have such a large emergency fund to get you through any tough times, I’d have to say go with your gut and get the 15yr.

Sure, you’re saving a ton in interest. You’re also getting that monkey off your back in half the time. Being mortgage free in 15 years instead of 30 is worth the possible loss in opportunity costs.

J.D. Pohlman says

I would 100% go with the 15 year in your situation. Think of investing the full amount of your mortgage payment for the 15 years after you are paid off. That will get you a lot more than investing the difference in payments over 30 years. Go with the 15 year, and don’t look back!

Cassie says

Lazyman,

I know you are not most people-but I’ve read 97.3% of those that intend to pay a 30 year note off in 15 years fail to do so. That flexibility allows skipping the extra payments for a better vacation, a wedding a new pool etc. I would not consider the scenario of a 30 paid like a 15 for this reason.

So let’s say the payment choices are $2000 a month for 15 years or $1500 a month for 30 years and that you can easily allocate $2000 to a combination of mtg payments and investing.

If you choose the 15 year mtg, you can invest $2000 a month for years 16-30 @ 7% giving you a final balance of 646,702.00. You spent 360,000 in mtg (P&I) payments 360,000 in investment principal and you end up with a paid for home (at year 15) and $646,702 in cash (at year 30).

For the 30 year, you invest $500 for 30 years @7% final balance $638,287.32. You spend $540,000 in mtg (P&I) payments, $180,000 investment principal and end up with a paid for home & $638,287 in cash (at year 30).

Go with the 15

Patrick says

Seriously? you’d exchange another 15 years of payments just so you can have some ‘flexibility?’ That’s not very financially smart.

Often times, in a 30 year note you have to go 18 years just to reach the point where the principal payment matches the interest. The average time an owner keeps a house in the U.S. is 6 years. Most of those homeowners don’t make any money with a 30 year note.

15 years seems more manageable, and after 180 payments you really are free of the debt.

Alex | Perfecting Dad says

Lazy Man, I don’t know if you should dismiss a variable mortgage so quickly. Do the math on them. If you’re able to get a 1% or so lower than a fixed for say five years, then it would have to be 1% higher for more than five more years to counteract that because 1: You’ve paid much more principal in the beginning and 2: You’re paying those higher rates with inflated dollars. 10 years down the line your increased rates are going to be paid with dollars worth half what they are now.

Variable is almost always better than fixed so long as you can afford the risk. Run the numbers with your variable rate and your fixed rate side-by-side. Make the payments the same and include inflation to check what would have to happen to make fixed better.

There have been rare times here in Canada where variable was a worse deal than fixed, but that was because the cost of long-term and short-term debt to the bank was screwed up during the financial crisis for a short time.

Bill says

A couple things you should add to your considerations.

First, looking at a 15 year versus an accelerated 30 year amortization is a good idea. It is important to see that 33k number as a meaningful comparison of the two loans. Don’t forget however that it is 33k due 15 years from now, present value terms that’s only 18.5k discount at swaps. In addition that extra interest expense is tax deductible. At a 28% marginal rate you are paying 13.3k more for the 30 year than the 15 year in today’s dollar. It’s obviously more expensive but less so than your simple 33k estimate, for that 13k you have the option of pay $700 less in any given month. You’ve said that doesn’t have much value for you but for others it might.

Second, you said some seemingly inconsistent things in your post. You instantly rejected an ARM because of the risk of interest rates going up. That says to me you think the probability we have higher rates in the future is large. If you believe that then a 30 year loan should look relatively more attractive. If for example 10 years rates shoot up to 8% two years from now, the 15 year mortgage has you locked into a much faster principal amortization of very low interest debt, the 30 year with its slower amortization gives you a lot of spare cashflow to invest at market rates. I’m not talking about equity returns, this is a simple fixed income interest rate play.

You can pretty simply analyze the situation yourself in Excel.

I’m not saying rates are going up and I didn’t calculate how much they have to go up before the 30 year becomes the better choice. I also don’t really know what your view on future rates are. I’m just pointing out that the conclusion that ARMs are a terrible idea when applied correctly to fixed rate loans will very often yield the conclusion that the longest loan term is best.

Wow, you guys are killing it today with the great advice.

DC_Man, I don’t think the flexibility in our situation is worth the extra 33K interest. Over the 15 years that’s almost $2000 a year.

Rob, I usually don’t go with the psychological “get the monkey off your back” and instead look for the best mathematical situation. However, in this scenario you summed it up pretty well. There’s something to be said for owning the house free and clear in 15-years.

J.D Pohlman, that’s what I was thinking. Cassie in the next comment does a little more math on the scenario.

Cassie, thanks for all the math. I realize it was a hypothetical as I didn’t really show my payments. That said, the numbers weren’t that far off and it made sense. I think it’s going to be a minimal difference and in doubt, I go back to Rob’s “get the monkey off your back.” I also agree that while people intend to pay off a mortgage early… that doesn’t always happen. I think there’s something to being “forced” to save to make the payments.

Patrick, there’s something to be said for making another 15-years of payments if they are going to be lower and the money is going to be invested. I think the flexibility is something to consider.

Alex, I’m trained to give up on adjustable mortgages after the debacle of 2008 :-). I see what you are saying now. When I look at 5/1 ARMs, the rates on Bankrate.com are 3.05% and the 15-year is 3.65%. So it’s only 0.6%. If it shoots up to between 5 and 6 like it was in the 2006-2009 range, I think I’m better with the 15-year deal.

Bill, your comments might have been the most interesting. Because the house is in a summer destination, we may end up renting it out at some point, which would make deducting the interest not possible. As for feeling that the risk of interest rates in the future going up, it is worth considering that Bankrate has today’s rates just about at the 5-year low. If they had the option it would probably be a 10-year low as well. I don’t know if I see rates going up to 8%, but I could it going up to 5-6%. At that point, is the 30-year with its slow amortization really going to help me out that much? Plus if the rates do shoot up, after I pay off the mortgage in 15-years I’ll have a lot more money to invest at those higher rates. Still your point, especially with how you worded it in the conclusion is a valid one worth thinking about.

Go with the 15 year. I never had the discipline to ‘invest’ the difference in between the 15 year and 30 year notes. Although we paid ours like a 15, we still burned extra money on interest until we refinanced to a 15 year.

I think I value liquidity and flexibility too much. The $2K in “cost” to know that you can access a bit over $8,640/yr seems reasonable to me.

In addition to these calcs (by the way it may be easier if you used DinkyTown rather than excel) it would be prudent to use real numbers…if you got the 15 year mortgage would you actually be paying that 15 year price or would you be pre-paying it? Then use that whole number to determine the outcome.

So if your payment was $2300 on the 15 year Mortgage and $1650 (Assuming a $325K mortgage) but you are really going to throw $3k/month then every assumption changes.

I had the same problem some years ago. I opted for the variable interests. The fixed interest rates are usually very high and looking back the last 20 years, the mortgages with variable interests have been cheaper.

Now, for the term, I´m also adept of getting out of debt as quickly as possible. Investing in mutual funds or stocks has not worked for me in the past, so I would go the safe way.

I would definitely recommend you take a look at the 5/1 ARM again. If you talk to the mortgage agents, you’ll find the rates are actually closer to 2.75% now a days. A 1% lower rate will let you build up a fair bit of equity early. And even if rates rise by a lot (there is a cap of 5% over the initial rate), it seems for someone in your financial situation, you can manage the risk.

Mortgage interest on vacation homes is tax deductible even if you rent it out. The only requirement is that your personal use of the home is greater than 10% of the number of days its rented.

The value of the different mortgages obviously depends on what happens in the future, if rates go up, when, and for how long. Asking if investing smaller amounts of cash for longer with a 30 year is better than investing more in the future with a 15 year is akin to asking should I save for retirement now or later? Compound interest compounds! and often makes early small investing better than large later investing. But again there is no definitive answer.

As an example I took your mortgage, a 320k loan at 3.75% for 15 years or 4.5% for 30 years. You spend $2327 a month in either case for 30 years. The difference between $2327 and your mortgage payment is invested monthly. Every 12 months in both cases you invest the tax benefit from your mortgage interest deduction, assuming a 28% marginal rate. I also assume the return you earn is fully taxable as ordinary income paid monthly. I assume that you earn 2% annually for the first 2 years, 8% for the next 10, and 6% from year 12 to 30. After 30 years you will have a total of 671k with a 15 year loan and 709k with a 30 year. Again this is assuming that you are investing the money in the most tax inefficient way possible, if you can do any better than ordinary income rates you are even better off with the 30 year.

If you are putting the money in a tax deferred account you have 804k with the 15 year and 995k with the 30 year at the end of the period.

Obviously these numbers are particular to the scenario I chose. You could pick plenty of scenarios where the 15 year is better, those will generically be lower interest rate scenarios.

The cutoff is very roughly when interest rates rise above your mortgage rate. In the tax deferred setup, 2% for two years, 4.5% from year 2-30, the 30 year leaves you 700k versus 678k in the 15 year case. The same setup but with a 4% interest rate from 2-30 it’s 640k in the 30 year case and 646k in the 15 year case.

Taking out a mortgage makes a person naturally very the bond market (just like buying a bond makes you long bonds). The longer you borrower money for the longer you are. You have to decide if you want to take on more interest rate risk by taking the longer mortgage and if that extra risk is worth paying a higher interest rate. This is a particularly expensive choice currently as the 15yr-30yr spread is at its widest levels ever.

I’d agree with others who suggest looking at an ARM, but I wouldn’t look long. Years ago (1984?) I bought a house with an ARM and did well. When time came for an adjustment, the rate went DOWN. That’s not likely to happen again and some ARMs now do not allow that. After the rate fluctuated several times I refinanced to a 15year loan. In 1998 I moved and found a 20 year loan. The rate was lower than 30 year, the payments were lower than 15 year. I’ve not seen that again. In 2003, I refinanced to a 15 year.

Recently, I saw where Quicken loans was touting a 7/1 ARM. Why pay fixed rates when you may not be there for 7 years? I did the math and I’m keeping what I have.

I did some analysis of fixed vs ARMs in the past and know that in some countries, it’s almost impossible to get fixed rates. I think the banks do a good job of estimating future rates and I don’t think you’ll come out a lot different either way. The question is risk. Do you want to take the risk or do you want the bank to take it? Are you better at guessing future rates than they are?

I think ARMs make good sense when rates are high or homes appeciate quickly. Thinking of today’s home & loan market and the next few years, I’m not sure ARMs make much sense.

One thing to consider about the difference in 15 vs 30 years is the savings of 15year rates is GUARANTEED. You will save .75% (4.5%-3.75%) for 15 years, then 4.5% for 15 years. No risk. Any other investment involves risk, this one doesn’t. Also, you’ll have to pay taxes on any investments, so you’ll need to make more just to break even. If you believe mortgage rates will go up, what do you think about tax rates? Will capital gains rates still apply? With the US budget the way it is, there are certainly no guarantees. I suspect you’re one of those mean awful rich people and the government will want to stick it to you (and me).

After a lot of soul searching, I’d probably go with 15 years. One more thought, two of my children bought a home in the last couple of years with a fixed 30year rate. Their intent was to make extra payments to pay it off in 15 years. They are both VERY disciplined with their money. Neither has made an extra payment.

Ive opted for 30yr loans myself to maximize our flexibility. You’ll likely come out ahead with the 15yr, but if something unexpected happens (kids, job loss, unforeseen expenses) the additional flexibility may be a significant benefit

Take the difference between the 15 and 30 yr note and apply it as a principal payment every month on top of your 30 yr mortgage. You have the lower ‘required’ payment of the 30 yr and that extra principal adds up quickly reducing your principal balance. That principal reduction means money you aren’t having to pay interest on every month.

That’s one option that I considered, but I getting the lower interest rate to begin with and paying it over a shorter time is going top you ahead of the 30-year mortgage. Of course with the 30-year you have more of a safety net in times of trouble. You can simply choose not pay the extra which will feel like paying lower payments.