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15-Year vs. 30-Year Mortgage
Buying a new home can be one of the most exciting events in your life. However, since it's typically the largest financial transaction you're likely to face, taking the time to educate yourself about your options can yield huge dividends over the long term - especially when it comes to financing. Historically, fixed-rate mortgage customers have generally opted for conventional 30-year mortgages. With the significant decline in long-term interest rates during the last several years, loans with shorter terms (e.g., 15 or 20 years) have risen in popularity. Assuming you could afford the higher payments associated with, say, a 15-year mortgage, does it make sense? Or should you stick with the "tried-and-true" 30-year term?
The Interest Factor
Conventional wisdom seems to argue in favor of a 15-year mortgage, because of the projected interest savings. Not only does a 15-year loan typically carry a slightly lower interest rate (a 25- to 50-basis point reduction is common), you end up paying off the debt in half the time of a 30-year loan. Example: Let's compare a 30-year loan at 6.75 percent with a 15-year loan at 6.50 percent. On a $150,000 loan, your total interest payments would be $200,243 for the 30-year mortgage, but only $85,199 for the 15-year mortgage. That's a savings of $115,044 for the 15-year loan - and you'd own the home "free and clear" 15 years sooner. If interest savings were the only factor to consider, the 15-year would be the clear winner. In general, interest paid to buy, build or substantially improve a personal residence (your main home plus one other dwelling that is treated for tax purposes as a personal residence) is deductible, provided the debt is secured by the residence(s) and does not exceed $1 million. The deductibility of home mortgage interest is one of the last great tax breaks available to taxpayers of all income brackets. In our example above, assuming you were in a combined federal and state tax bracket of 40 percent, the after-tax interest savings of the 15-year mortgage, while still significant, would be reduced to $69,026.
The "30-Year-And-Invest-the-Rest" Strategy
Even after taxes, the 30-year mortgage ends up costing you more in interest over the long term. So why would you consider a 30-year loan? Because you may come out ahead by investing the cash flow savings associated with the lower monthly mortgage payment. Stated another way, you could either pay off your home mortgage in 15 years and then allocate the available cash flows to long-term savings and investments or service the debt for a longer period, buy start building (or adding to) your investment portfolio now. Again, using our example, the monthly payment on the 30-year mortgage is only $973 compared to $1,307 for the 15-year mortgage - a difference of $344. However, after considering the tax savings on the interest portion of the payments, the after-tax differential for the initial monthly payment would be $346. (This amount would continue to increase as the interest portion of the 15-year loan payments declines relative to the interest portion of the 30-year payments.) Investing the additional cash flows in a diversified portfolio of securities or mutual funds on a regular (e.g., monthly) basis could enable you to accumulate more wealth in the long term. The "could" here implies uncertainty, specifically the uncertainty relating to your portfolio's performance.
Analyzing the Impact of Investment Performance
Table I illustrates the range of potential outcomes for our $150,000 loan example. The 30-year-and-invest-the-rest strategy assumes that during the first 15 years, you make monthly investments equal to the additional cash flows associated with the lower payments. In contrast, the 15-year loan scenario assumes that once the 15-year loan is paid in full, you then invest an amount equal to the remaining after-tax monthly payments on the 30-year loan (i.e., to maintain an "apples to apples" comparison). Results are projected over a 30-year period. The following investment and tax rate assumptions also apply: 1) Pretax yield (interest and dividends) of two percent annually; 2) combined federal and state ordinary and long-term capital gains tax rates of 40 and 24 percent, respectively; and 3) 25-percent portfolio turnover rate. The pretax investment growth rate rages from zero to 10 percent annually. As Table 1 illustrates, the 30-year-and-invest-the-rest strategy would produce a larger after-tax investment portfolio at the end of the 30-year analysis period so long as the investment portfolio enjoyed a pretax annual growth rate of four percent or higher (i.e., a six percent total return). At higher growth rates, this strategy can generate significantly more wealth over the long-term. For example, assuming an eight percent pretax growth rate (10 percent total return), the 30 -year mortgage scenario produces approximately $150,000 more after tax at the end of 30 years than the 15-year mortgage scenario.
Despite the apparent wealth accumulation advantage of a 30-year mortgage, many homeowners prefer the imposed savings discipline inherent in the 15-year mortgage. Retiring the debt at an accelerated rate is akin to making an effectively risk-free "fixed-income" investment (the interest savings associated with the debt payments is essentially equivalent to receiving interest income). Moreover, from a psychological perspective, the peace of mind associated with owning your home debt-free in only 15 years may be an important, albeit intangible, factor in deciding which loan term is preferable. On the other hand, a 30-year mortgage may appear "less daunting" in the face of uncertainty with respect to cash flows from your (and/or your spouse's) employment or business. Furthermore, in the event your family encounters a financial hardship down the road (e.g., loss of job), it may be easier to tap your investment account with the 30-year loan than to take out a home equity loan against your larger home equity with the 15-year loan. In any case, consulting with your advisors concerning this and other home purchase-related decisions can help you avoid costly mistakes.
Because the materials covered in this article are complicated, this article should not be regarded as offering a complete explanation and should not be used for making decisions. Any suggestion should be reviewed with your personal financial and tax advisor.