Plot spoiler: Even if you can afford the higher monthly payment of a 15-year mortgage, consider getting a 30-year term, instead. Invest the difference, and in 15 years (with a 6% return) you’ll have enough to pay off the mortgage, and you’re not locked in to the higher payment
If you’ve had your current mortgage for more than about two years, now might be a good time to refinance.
This assumes, of course, that you’re planning to own your home for several more years and that you have positive equity (the value of house is more than the amount of the loan that you would be seeking). Interest rates are being held down by the Fed in an effort to get the economy going again, so it’s a good bet that they’ll stay low at least for the next few months.
I made a few calls and found that going rate for a fixed-rate 15-year term loan is about 4.65%, and the similar rate for a 30-year loan is 5.25%. If you’re only going to be in your house for a few years, then you can save a few pennies with an adjustable rate loan, but with fixed rates so low, you don’t really save much.
Example: A $200,000 loan
If you need to finance $200,000, the monthly payment for the 4.65% 15-year loan is $1,545. The monthly payment for the 5.25% 30-year loan would be $1,104 which is $441/month less. Over the life of the 15-year loan, you would pay a total of $278,165. Alternatively, if you chose the 30-year loan, you would pay a total of $397,587 – almost twice the amount borrowed. You might think that if you can swing the higher payment, you’re better off paying it off quickly. After all, who wouldn’t want to save $119,422?
However, there are some advantges to paying off your mortgage at the slower rate:
- You have less of your money tied up in a house, and
- If you lose your job, you’ll be grateful that you have a lower monthly payment.
The effect of inflation and tax deduction
There are two factors that lower the real cost of the extended mortgage: inflation and the tax deduction. Inflation means that paying someone $1,000 in 30 years costs less than paying them that same $1,000 today. In addition, the interest paid on your mortgage is generally tax deductible. Let’s assume you’re in the 28% tax bracket. Let’s also assume inflation continues at 2.5% per year. The present value of the total stream of payments and tax deductions for the 15-year loan is $212,970, and the same for the 30-year loan drops to $237,503. The effect of inflation and taxes reduces the advantage of paying it off quickly to $24,532.
Invest the difference
Hey, what if I take the money I save every month by paying the lower payment, and invest it? What would $441 invested monthly at, say, 6%, come to in 30 years? Well, I only get to invest $441 for the first 15 years, because after that I have to start taking money out of the pot to cover the monthly payment. It turns out that’s not likely a winning strategy — it might be if you could get 7 or 8% investment return, but not at 6%.
Invest the difference for 15 years then pay off the loan
A better solution is to invest the difference for 15 years and then take the value of the investment to pay off the loan. This turns your 30-year loan into a 15-year loan, and gives you extra flexibility over the life of the loan. If an emergency arises during the loan period, you wouldn’t have all your money tied up in the house. Investing $441/month for 15 years at 6% yields $128,238. Fifteen years into a 30-year loan, the $200,000 loan will have $137,385 remaining on the principal. You could pay off the loan with the investments plus $9,147 out of pocket, but since it’s 15 years in the future, that sum will seem like $3,746 today. Not bad. And if you can manage to average an investment return of 7% over the life of the loan, you’ll not only be able to pay off your loan at the 15-year mark, but you’ll have an extra $2,381 in your pocket.
Summary
In sum, think twice before chasing the lower rate of the 15-year term loan. You might do better by investing the difference and using the investments to pay off your loan in 15 years.
Disclosures: No positions.
Image credit: robotography at Flickr.
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