Take a 15-Year Term If You Can Afford the Payment
May 4, 2012
The Case For the 15-Year Mortgage
The case has
never been stronger because, in the post-crisis market, the
rate advantage over the 30-year has never been larger. The
rate advantage is about .875%, whereas prior to the crisis,
it was .375% to .5%.
$100,000 loans, one a 15-year at 3.125% and the other a
30-year at 4%. The respective payments are $696.61 and
477.42. After 15 years, the borrower with the 15 has paid
$39,454 more but is out of debt whereas the borrower with
the 30 still owes $64,543.
The Counter Argument For the 30: Investing the Cash
argument is that a disciplined borrower can take the 30 and
invest the difference in payment between the 30 and the 15,
in that way offsetting the higher interest rate on the 30.
Some financial planners recommend this approach to their
clients as part of a program to build wealth faster.
Weakness of the Counter Argument For the 30
in making such a program work is that the rate of return on
the invested cash flow must exceed the rate on the 30 by an
amount that depends on how much higher the 30-year rate is
than the 15-year rate. For example, in 2006 when I first
looked into this issue, I used rates of 6% and 5.625%
on the 30 and 15. I found that over a 15-year period, the
cash flow savings had to yield 7%, or 1% more than the rate
on the 30, to just offset the higher interest rate on the
30. This can be termed the break-even return on the cash
flows. To come out ahead, the borrower has to earn a return
above the break-even return.
repeated the exercise using rates of 4% on the 30 and 3.125%
on the 15. With these rates, the break-even return is 6.15%,
or 2.15% higher than the rate on the 30. The larger rate
spread between the 15 and 30 increases the difficulty of
developing a profitable reinvestment strategy.
looms even larger if the borrower holds the mortgage for
less than the 15 years I assumed. The break-even rate is
higher over shorter periods because the difference in the
rate at which the 15 and the 30 pay down the balance is
largest at the outset and declines over time. The shorter
the period, the higher the reinvestment rate must be to
offset the larger difference in balance reduction.
Average mortgage life today is somewhere between 5 and 10 years. At 10 years the break-even rate rises to 8.02%, and at 5 years, it jumps to 13.69% -- a whopping 9.69% above the rate on the 30.
These calculations assume that the
borrower makes a down payment of 20% or more. If the down
payment is less than 20%, the borrower must pay for mortgage
insurance, and the premiums are higher on the 30-year loan.
For example, if you put down 5% and pay standard insurance
premiums, the break-even rate rises from 6.15% to 7.01% over
15 years, from 8.02%
to 9.56% over 10 years, and from
13.69% to 16.88% over 5 years. Note: All the break-even
rates shown above are derived from
These required returns are forbiddingly high for any borrower who would invest the cash flow saving by acquiring financial assets. There is no way they can earn such returns without taking very large risks. Most borrowers probably fall into this category.
Where the Counter Argument For
the 30 Might Apply
But there are
some borrowers for whom the cash flow reinvestment strategy
might make sense. One is the borrower who is eligible for
but not currently utilizing IRA, 401K or other qualified
tax-deductible or tax-deferred plans. Borrowers who use
their cash flow savings to invest in these vehicles, who
would not do so otherwise, can earn a very high rate of
return because of the tax benefits. If the borrower’s
employer makes matching contributions, the return is even
category of borrowers who can earn a very rate of return are
those with high-cost debt. A borrower paying 18% on credit
card balances earns a return of 18% by paying down the
In my 2006 article on this topic, I argued that borrowers who have not fully exploited all tax-advantaged investments, or who have high-rate credit card balances, are unlikely to have the iron discipline required to invest the cash flow savings on their mortgage month after month. But the financial planners who wrote me argued that they have developed special plans for borrowers in such situations which provide the discipline that is required. But until I see such plans along with evidence that they work, I will remain skeptical.