Is There a Yield on a Shorter Mortgage Term?

 December 20, 1999, Revised October 25, 2007

A shorter-term mortgage can be viewed as an investment, where the amount invested consists of the larger monthly payments relative to those on a longer-term loan, and the return is the lower balance when the loan is paid off. The return is higher the larger the rate difference between the short and long mortgage, the smaller the down payment, and the shorter the period to loan payoff.

"Your recent column suggested that a larger down payment can be viewed as an investment yielding a return. This made me wonder whether you can view a shorter term mortgage in the same way?"

Indeed you can, and this is a very insightful way to look at it. A shorter-term mortgage is an investment, although it is a little different than most other investments.

Typically, an investment consists of a lump sum paid out at the beginning, and the return is a series of payments received over time. This is the way it is, for example, with investment in a deposit or bond.

By contrast, when you invest in a shorter-term mortgage, your investment is a series of payments equal to the difference between the monthly payment at the shorter term and the payment at a longer term. And the return is a lump sum, equal to the the larger proceeds you receive at time of sale because of the smaller loan balance that must be repaid at the end of the period.

Let's say you are borrowing $100,000 and choosing between a 30-year fixed-rate mortgage (FRM) at 7.5% and a 15-year FRM at 7.125%. The .375% difference is typical. Monthly payments of principal and interest are $699.22 for the 30-year loan and $905.84 for the 15-year. The difference is $206.62 each month. That's your investment.

You expect to stay in your home seven years. At that point, the balance of the 30-year loan will be $91,833 and the balance of the 15-year loan will be $66,137, for a difference of $25,696. That's your return. On an annual basis, it amounts to 10.72%. If the difference in interest rate had been greater than .375%, the return on investment would be higher, and vice versa.

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. This increases the return on the 15-year loan considerably. If you anticipate paying 5% down, for example, the higher premium on the 30-year FRM will raise the 7-year return on the 15 from 10.72% to 15.74%.

An important feature of this type of investment is that the return is inversely related to how long you expect to stay in your house. If you remain 3 years instead of 7, for example, the return on your investment in the case without mortgage insurance rises from 10.72% to 16.21%. If you remain for 15 years, the return falls to 8.60%. That's because you must wait 15 years to realize the return.

Calculator 15a, Mortgage Term Calculator: Investing in a Shorter Term lets you calculate the return on your own deal. You enter two terms, their interest rates, your anticipated down payment and your expected period in the house. The calculator determines your rate of return.

This way of looking at a shorter term reveals how much more effective it is as a way of building equity than the common practice of systematically making additional monthly payments on a 30-year loan. Assuming you aren't paying PMI premiums, the rate of return on the additional payments made on a 30-year loan is just the interest rate on the loan. If a 15-year loan is elected at the outset, the return is substantially higher, especially if you don't expect to be in the house very long.

Most borrowers electing a 30-year term do it because they can't afford the monthly payment on a shorter term. Some elect the 30-year term, however, because they plan to invest the difference in payment. To make this a sensible investment strategy, however, the return must be higher than the return on a 15-year mortgage. Not many borrowers have access to such investments.

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