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Can You End Up Richer Taking a Longer Term?

18 April 2006, Reviewed October 25, 2007, April 9,
2011

A strategy of taking a 30-year loan and investing the cash flow difference between that and a 15-year loan is almost bound to be a loser unless the borrower has very high cost debts that can be paid down, or unexploited tax-deferred investments. Otherwise, even if you are disciplined enough to actually make these monthly investments regularly, it is very unlikely that the return will be high enough to leave you ahead. This is particularly the case if you are not putting 20% or more down, and if your time horizon is short.

Yes. The flaw is that the investment return required to make the plan work is much too large. You will almost certainly end up poorer than if you take the 15-year.

If 15-year and 30-year loans carried the same rate, say 6%, and you earned 6% by investing the difference in monthly payments, you would end up in the same place. Your investment return would have to exceed 6% to come out ahead on the 30.

Assuming 15-year loans carry a lower rate, which is almost always the case, the required return to break even rises. For example, assume the 30-year rate is 6% and the 15-year rate is 5.625%, a rate difference of .375%. The break-even rate would then be 7% over 15 years, 7.86% over 10 years, and 10.49% over 5 years. Very few mortgage borrowers today keep their loan for 15 years.

The calculation above assumes the interest rate is the only difference between the two loans. But if the down payment you expect to make is less than 20%, you will have to pay for mortgage insurance, and the premiums are higher on the 30-year loan. For example, if you put down only 3% and pay standard insurance premiums, the break-even investment rate is 7.49% over 15 years, 8.95% over 10 years, and 12.78% over 5 years.

All the required returns shown above, and in the table below, were calculated from calculator Mortgage Term Calculator: Investing the Cash Flow Savings on a Longer-Term Mortgage.

The upshot is that a strategy of taking a 30-year loan and investing the cash flow difference between that and a 15-year loan is almost bound to be a loser. Even if you are disciplined enough to actually make these monthly investments regularly, it is very unlikely that the return will be high enough to leave you ahead. This is particularly the case if you are not putting 20% or more down, and if your time horizon is short.

For those who can afford the payment, the 15-year fixed-rate mortgage is a winner.

Some readers justifiably took me to task for not recognizing that some borrowers did indeed have access to high-return investments. A case in point 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 can earn a very high rate of return. The same is true of borrowers who use the savings to pay down high-rate credit card balances.

That I didn’t mention these possibilities in the article probably reflects my cultural chauvinism. I assumed 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 month after month.

I still believe that this assumption is appropriate for many if not most borrowers, but some financial planners who wrote me argued persuasively that it did not apply to everyone. They develop financial plans for borrowers in such situations, which they claim are successful in strengthening their discipline.

My modified rule would be, take the 15-year loan unless a) you have unexploited high-return investments, and b) you have a disciplined financial plan to channel the cash flow savings on a 30-year loan into those investments.

A strategy of taking a 30-year loan and investing the cash flow difference between that and a 15-year loan is almost bound to be a loser unless the borrower has very high cost debts that can be paid down, or unexploited tax-deferred investments. Otherwise, even if you are disciplined enough to actually make these monthly investments regularly, it is very unlikely that the return will be high enough to leave you ahead. This is particularly the case if you are not putting 20% or more down, and if your time horizon is short.

*"I can afford the large payment on a 15-year fixed-rate mortgage, but I plan to take a 30-year with a lower payment, invest the difference in the cash flow, and end up ahead. Is there a flaw in this plan?"*Yes. The flaw is that the investment return required to make the plan work is much too large. You will almost certainly end up poorer than if you take the 15-year.

If 15-year and 30-year loans carried the same rate, say 6%, and you earned 6% by investing the difference in monthly payments, you would end up in the same place. Your investment return would have to exceed 6% to come out ahead on the 30.

Assuming 15-year loans carry a lower rate, which is almost always the case, the required return to break even rises. For example, assume the 30-year rate is 6% and the 15-year rate is 5.625%, a rate difference of .375%. The break-even rate would then be 7% over 15 years, 7.86% over 10 years, and 10.49% over 5 years. Very few mortgage borrowers today keep their loan for 15 years.

The calculation above assumes the interest rate is the only difference between the two loans. But if the down payment you expect to make is less than 20%, you will have to pay for mortgage insurance, and the premiums are higher on the 30-year loan. For example, if you put down only 3% and pay standard insurance premiums, the break-even investment rate is 7.49% over 15 years, 8.95% over 10 years, and 12.78% over 5 years.

All the required returns shown above, and in the table below, were calculated from calculator Mortgage Term Calculator: Investing the Cash Flow Savings on a Longer-Term Mortgage.

The upshot is that a strategy of taking a 30-year loan and investing the cash flow difference between that and a 15-year loan is almost bound to be a loser. Even if you are disciplined enough to actually make these monthly investments regularly, it is very unlikely that the return will be high enough to leave you ahead. This is particularly the case if you are not putting 20% or more down, and if your time horizon is short.

For those who can afford the payment, the 15-year fixed-rate mortgage is a winner.

**Break-Even Rate of Return on Investment of Cash Flow Differences Between
15 and 30-Year Mortgages**

Interest Rate on 30 | Interest Rate on 15 | Down Payment | Years Until Payoff | Break-Even Return |

6% | 5.625% | 20% | 15 | 7.00% |

6% | 5.625% | 20% | 10 | 7.86% |

6% | 5.625% | 20% | 5 | 10.49% |

6% | 5.625% | 3% | 15 | 8.82% |

6% | 5.625% | 3% | 10 | 10.99% |

6% | 5.625% | 3% | 5 | 13.26% |

6% | 5.50% | 20% | 15 | 7.34% |

6% | 5.50% | 20% | 10 | 8.49% |

6% | 5.50% | 20% | 5 | 12.00% |

6% | 5.50% | 3% | 15 | 9.20% |

6% | 5.50% | 3% | 10 | 11.65% |

6% | 5.50% | 3% | 5 | 14.76% |

**October 2007 Post-Mortem**

Some readers justifiably took me to task for not recognizing that some borrowers did indeed have access to high-return investments. A case in point 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 can earn a very high rate of return. The same is true of borrowers who use the savings to pay down high-rate credit card balances.

That I didn’t mention these possibilities in the article probably reflects my cultural chauvinism. I assumed 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 month after month.

I still believe that this assumption is appropriate for many if not most borrowers, but some financial planners who wrote me argued persuasively that it did not apply to everyone. They develop financial plans for borrowers in such situations, which they claim are successful in strengthening their discipline.

My modified rule would be, take the 15-year loan unless a) you have unexploited high-return investments, and b) you have a disciplined financial plan to channel the cash flow savings on a 30-year loan into those investments.

## April 2011 Post-Mortem

When I took another look on April 8, 2011, the rate spread between 30s and 15s was twice as large as it was in 2006, reflecting the general increase in risk premiums that followed the financial crisis. This materially increases the break-even returns on investment shown in the table.