30 yr. mortgage vs. 15 yr. Can I make $$$ investing the difference in monthly payment?

Question

I've got 18 years until retirement and I'm looking at buying a home. I was planning on a 15 year mortgage so I could own the joint when I'm retired. My lender is trying to sell me on 30 yr vs 15 year mortgage. He says with the 30 year, I can invest the monthly difference in payments about $500.00/ month in a tax deferred account and be way ahead in 15 years...I could pay off the mortgage and have big money in my pocket vs. just paying off the mortgage.(with a 15 yr mortgage). What doesn't make sense to me is the fact that today's loan rates don't seem to allow sufficient spread against what I could earn with conservative investing. A 6.2 to 7% mortgage rate seems like the same percent return I might get from a reasonably diversified investment. This seems to me like a wash. What am I not understanding? FWIW I am pretty good at saving. I'm an Automatic Millionare in the making....not boasting but I read that book and found it mirrored the stuff I've already been doing with my finances

Answer 1

It's all about opportunity cost. He seems to think you can get risk free returns in excess of 7% for 30 years. Why would it have to be risk free to be equivalent? Because your loan payments wouldn't vary...there's no risk there. As always, if you're willing to take more risk, you CAN make more of a return...but since you're thinking about retiring, you should probably opt for the 15yr mortgage and be guaranteed that the extra money paid each month is going toward your principal ...in effect earning 6.2-7%.

Answer 2

Taking investment advice from someone trying to lend you money is generally NOT a good idea. Most likely, they want you to pay more in interest, as you would with a 30-year mortgage (a LOT more).

This is a really complex question, but I'll try to answer it simply. You can use Quicken or MS Money to help you calculate this. Both have financial calculators where you input amounts and see what the outcome will be in 5, 10, 20, 50 years.

There are four calculations you need to make. First, calculate the payment on the 30-year mortgage, then the payment on the 15-year mortgage (remember to look at how much interest you PAY with each). Next, calculate how much you'll have if you invest the difference in the payments over the 30 year life of the loan (say 8% annual return to be safe). Finally, you'll need to calculate how much you'll make investing the ENTIRE payment of the 15-year loan (because once you pay off the loan, you can invest all that money). Compare how much you'll make to how much you'll spend in interest. This can really be revealing. Most likely, you should go with a 15-year mortgage and set aside whatever you can for retirement.

Answer 3

See http://www.rogerv.com/leverage.html

There are a few benefits to investing instead of pre-paying:
a. A good portfolio should yield more than the raw cost to borrow. If you can make 8% but borrow at 6%, why not borrow as much as you can?
b. You add tax benefits to the above, making your effective rate even lower - for example, if you're in a 25% bracket, the mortgage is under $1Mil, then your effective rate is actually in the high 4's.
c. Liquidity. Cash in the bank is always superior to equity in the home, from a risk perspective.
d. Inflation. You really only benefit from inflation _if_ you have a higher loan-to-value mortgage, because the mortgage is steadily devalued while your expenses and income stay level with inflation.

Houses are designed to store people, not cash. Paying off the mortgage as an ideal is 100% purely a byproduct of real estate law from the 1930's. The only exception to this is if you will be making entirely tax-free income when you do retire (ie. social security or Roth IRA proceeds or certain government pentions). Assuming you still need a tax write-off during retirement, mathematically, it is superior to maintain a mortgage.

Counterintuitive, yes, but then the world was once flat, and in the early 1940's smoking was good for you.

Your mortgage lender should be able to clearly demonstrate the numbers of both choices for you to compare. Also, he/she should involve the counsel of your CPA or tax professional to confirm details.

Best of success!

Answer 4

What's the rate on the 15 year loan and the rate on the 30 year loan? What rate are you assuming for your investment? I can run a worksheet for you.

Answer 5

Hello -

Very interesting topic. May I ask what is your tax bracket and if you have an IRA, 401(k) or other pension plan?

The reasoning being that the 30 year mortgage can allow you to access money on a dollar for dollar basis tax free. Please note that is tax free and not tax deferred.

Then the other item which would need to be considered is what your life expectancy currently is as we want to make certain you do not out live your money.

Lastly, do you have a family whom you wish to leave an estate, or a possible charity you may wish to support?

These are other variables which must be considered. That being said, I'm going to leave that aside and respond to the original premise:

Would consumers benefit more if we helped them to understand the advantages of 15-year amortization schedules and pre-paying principal? Let's examine the pros and cons of both strategies.

Leveraging Your Property. In order to understand why you'd want to borrow as much as possible for your home purchase, you must first grasp the concept that equity has a zero rate of return. Here's an example:

If Consumer "A" buys a home for $300,000, and puts 20% down, then they have $60,000 in equity. Over the next 5 years, the property appreciates $100,000 in value. Consumer "A" now has $160,000 in equity.

Consumer "B" buys a home for $300,000, and puts no money down. At the end of 5 years, that same home is now worth $400,000. Consumer "B" has $100,000 in equity, which is the same appreciation as Consumer "A", a net $100,000.

As you can see, your down payment has nothing to do with your rate of return. What becomes important is how you choose to manage the $60,000 you didn't use as a down payment. If you use it for frivolous activities, such as buying toys or going to Las Vegas, it would be more prudent for you to use that money as a down payment. Especially since this will enable you to obtain a lower interest rate.

However, if you were to invest the $60,000 in a vehicle that can out-earn the cost of that debt, then this could be a formula for success. This is why some lending professionals suggest putting as little down as you possibly can, maximizing your tax write-off, and investing the rest. This principle has been applied for many years in the life insurance game. The old saying goes, "Buy term and invest the rest." The key component is taking the money you would have used as a down payment and creating an asset accumulation account. This account should earn a significant enough rate of return to enable you to pay your mortgage off entirely and achieve the ultimate goal of being debt-free.

Paying Your Home Down Rapidly. There are very few times over the course of my career that I have seen a client with zero debt and no financial difficulties. Choosing to pay off all of your debt can reduce stress and help you to gain freedom of cash flow for investment opportunities. A 15-year mortgage or a bi-weekly payment strategy provides structure. It can also put you on track to have your mortgage paid off within a set timeframe. Simply put, it contains built-in discipline.

It's important, however, to understand that regardless of how rapidly you pay your home off, you're not getting any greater rate of return on your investment than if you paid it off slowly.

Conclusion. So how does one determine which scenario is best? The choice depends entirely upon the individual. Savvy consumers who are disciplined, and are comfortable taking chances from an investment perspective, would do well with the first scenario. Over the course of time, it's been proven that your rate of return over the long-haul will be far greater than the rate you'd pay for a mortgage in today's rate environment. It's important to seek the advice of a skilled investment advisor to ensure success with this strategy.

The second scenario is best for those who have a difficult time managing their money or who'll sleep easier at night knowing they have a plan in place to pay their loan off more rapidly. Be sure that your budget can handle accelerated payments. When consumers "bite off more than they can chew" with a 15-year mortgage, they frequently end up having to refinance back into a 30-year schedule.

If you find this subject intriguing and would like to know more, I recommend that you read a book titled, Missed Fortune 101, by Douglas Andrew. It's an outstanding read that is very simplistic and goes into far greater detail than I can cover in this column. Douglas is a financial planner who advises safe-structured investments such as whole life policies and tax-free fixed income instruments.

Best Regards,
Darren Meade