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%. 

Consider two $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 Flow Savings

The counter 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

The challenge 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.  

I recently 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. 

The challenge 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 calculator 15b.  

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 higher.  

A second 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 balances.  

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.