The vast majority of Americans have a mortgage on their home. In this day and age, with high home prices despite rising interest rates, a mortgage has become a necessary means to home ownership. However, I don’t know of anyone who actually enjoys making their mortgage payments. In particular, nobody likes to pay interest on their loan to the bank. That said, some people have opted to shorten the term of their loan in order to lessen the blow of making interest payments. By choosing to pay off their mortgage over 15 years instead of the more traditional 30, borrowers decrease the amount of total interest that they will pay on their mortgage by increasing their monthly payments. If you can afford the larger monthly payments this may seem like a no brainer. However, let’s consider a situation where it may make more financial sense to go with the longer mortgage instead.
First of all, let me just say that there are a great many factors that go into buying a home, getting a mortgage, and budgeting for your monthly payments. This is intended solely to be an example and is not indicative of actual results or mortgage advice (if you need a good mortgage lender, let me know! I know a great one!). With that out of the way let’s look first at a $500,000 home with a 15yr mortgage for $250,000 at an interest rate of 4.25%:
As you can see, with a payment of $2,610 a month the borrower in the example would have their $250,000 mortgage paid off in 15 years and pay a total of $88,014 in interest[i]. Now, let’s look at the exact same example but with a 30-year mortgage:
In the example of a 30-year mortgage, the monthly payment goes down to $1,959 (a difference of $651 or $7,812/ year). The trade-off is that, in exchange for a lower monthly payment, the second borrower pays $104,398 more in interest[i]. That is a significant price to pay for a lower payment! Of course, for some there really isn’t an option as they simply cannot afford the higher monthly payments associated with a 15-year mortgage. However, for those who can afford the higher payments, we now need to circle back to the original question that was posed at the beginning of this blog post: is it always better to pay off your mortgage faster?
What if, rather than paying an additional $7,812 a year to your mortgage, you instead contributed that amount to an investment account averaging 8% a year for 15 years? With those assumptions one could expect their investment account to grow to around $212,112. In 15 years, the borrower would have invested $117,180 and seen a total return of around $94,932. If the borrower then ceased those contributions for the remaining 15 years of the loan, then (assuming the same return assumptions) the investment account would grow to $672,855.14! So, let’s review:
In this example, the borrower would be far better off taking the 30-year mortgage and investing the difference in payments for the first 15 years of the loan. By taking the 30-year loan, the borrower could potentially save up almost $700,000 in his investment account by the end of the loan. By contrast, if the borrower went with the 15-year loan they would not have that opportunity. Of course, one would hope that the borrower would start investing after paying off their 15 year mortgage but, as we have discussed in the past, missing out on 15 years of being in the market makes a massive difference!
With this blog post I am not trying to make the case that everyone should go with a 30-year mortgage over a 15 year. Instead, I am encouraging you to look beyond your initial perceptions and think deeper about your financial decisions. Yes, it would be great to pay less in interest on your mortgage but what is the opportunity cost of doing so? In this example, the cost is quantifiable (and quite significant!). Not every financial decision will be that way but many are. When facing a decision such as this I would encourage you to see out a trusted professional who can help you run through the various scenarios and craft a plan for your specific situation.
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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss. All examples are hypothetical and do not take in the effect of taxation, they are for illustrative purposes, only.
[i] No PMI ; home located in Grand Rapids, MI ; annual home owners insurance premium of $1,250 ; annual property tax of 1.5%
[ii] Same assumptions as the first example