The 30 Year Mortgage Paradox
Imagine you were considering your options on a $350,000 traditional home loan. Assuming you have a FICO score of 725 (US average(1)), your interest rate might be 6.259% for a 30-year fixed mortgage(2). At the end of 30 years, you’ll own your home outright for a total cost of about $776K–that’s $427K in interest(3).
By contrast, a 15-year loan will net you a lower interest rate of about 6.011%. Your monthly payments will be a little bit more, but you will own the home in half the time for a total cost of about $532K–only $182K in interest.
Assuming a paltry average annual appreciation rate of 10% (US average since 1980 has been 11.28%(4)), your house would be worth 417% it’s original value after 15 years. That $350K house would sell for about $1.5 million. Assuming you sold it and put the cash towards a bigger home costing $1.85M, taking out a new $350K loan to cover the remainder, you would only pay another $182K in interest in the second 15 years. Sell that house after another 15 years of 10% appreciation and you bank $7.7 million dollars. By comparison, the original house would sell for $6.1M in 30 years.
The net effect of the two fifteen year mortgages is living in a much better home for half the time and only paying a grand total of $364,000 in interest while neting about $1.6M more in value after 30 years. That’s quite a difference! You might be wondering why anybody would opt for a 30 year home loan.
On the other hand, you might have figured out that the 30 year $350K mortgage with its lower payments might be the most you can afford each month; that in order to make that same payment amount on a 15 year loan, you can only borrow $255K(5).
Well, that stinks. In the Seattle area, that’s 14.5% fewer houses in your price range and 20% less square footage in those you can afford (worse still if you want the same number of rooms)(6). However, it’s not all bad news. If you’re willing to go the 15/15 route, your second home would be worth $434K in today’s housing dollars(7), giving you 41% more selection and 22% more space than the 30 year home.
So what’s a buyer to do?
I suggest you start any home buying process by getting a pre-approval for a 15 year loan (higher payments, shorter term). Then, shop the market and see if you can find anything that will fit your needs for the foreseeable future. If you find a house you can call home, snatch it up and start building more equity at a faster pace. If you exhaust the market and can’t find the amount of house you need on your 15-year budget, go back to your loan agent and have them recalculate your pre-approval for a 30 year loan and resume your search.
If must choose the traditional 30 year loan, there is no need to fret. Your needs and budget simply lie in the margin between price ranges of these two loan types. Most of the home buyers out there fall into this range and the seem to be quite happy with it.
If you find you can fill your needs in a 15 year loan, congratulations; you are able to live well within your means and you will eventually reap considerable benefits from your good budgeteering.
References
#1 wikipedia.com - FICO info
#2 myfico.com - FICO/loan rate calculator
#3 moneychimp.com - Compound interest calculator
#4 ofheo.gov - US historical housing appreciation data
#5 equifax.com - Financial calculators
#6 redfin.com - House value mapping
#7 bls.gov - US historical inflation data
November 4th, 2006 at 12:46 pm
so there are a couple variables you need to consider before going down this road. first, interest you pay on your home reduces your taxable income, so it’s not an apples to apples comparison when you just look at interest. you also have to look at tax saved within your income bracket after you take the deduction. also, very few people will stick with their mortgage through the life of the loan. if you have any interest in re-financing and using your equity to do home repairs, pay for school, buy a boat, you may be better off going with the 30 year loan, paying over your rate, and banking on that equity. however, any principal you pay down will not reduce your taxable income, effectively making your taxes higher.
one option to reduce interest rates is buying down the rate. we were approved for 6 but bought down a percentage of the loan with what was supposed to be my bonus money to get the rate down to 5.875. we did the same on the second to great effect, getting it down to 9. this method makes up for a sub-par credit score or a complete disdain of interest, if you have that bug.
another option is to take a lower interest loan product for the second. we did was 30 year fixed on the first and 30-15 balloon on the second. yes, balloons are dangerous devices, but we are certainly going to re-finance before we hit the 15 year maturity date, making the lower interest rate more attractive. add in a buydown and you have yourself a pretty good loan deal.
i could talk about this all day. let me know if you have any questions or would like the name of my mortgage broker. he does great work.
December 11th, 2006 at 12:56 pm
Interesting analysis. There is an in-between alternative to the 15 or 30 year mortgages. You can “convert” any 30-year mortgage to a shorter term by paying extra every month on your mortage payments. The additional money you pay goes to principle (at least on the mortgages that I’ve had). Your total amount of interest goes down because you make fewer payments overall and you increase the proportion of your payment that goes toward clearing the debt. The only thing you lose out on is the lower interest rate available on 15-year mortgages.
You can calculate the exact additional payment you need so that your mortgage is paid off on the term you would prefer, whether that’s 15 years or 20 or whatever.
The catch is actually making the extra payment when you know that you technically don’t have to make it.
January 3rd, 2007 at 8:39 am
The key parameter is the 10% housing appreciation: if an asset is worth more than you are paying for it (the house is going up at more than the cost of money), then your scenario is correct. But what if the last 10 years of 10% growth have brought housing to it’s correct value (appreciated the value of land in line with the increased demand from the extra 100 million americans accumulated over the last 40 years). Or worse, what if people have over-corrected the value of land? (quite likely - the value should have gone up, but the fact that it has been going up creates speculation about the correct value of the increase). Then you need to model a world in which housing goes backwards or appreciates at say half the rate of inflation for 30 years, as it did in the 20s-30s?
Under those circumstances, both house buyers (the 15/15 and the 30) will be worse off than a person who stays out of the market, renting for 5 years, then buys in (they have spent less on rent than the mortgage and depreciation outgoings, and earned interest for 15 years).
January 31st, 2007 at 1:48 pm
You would have to take out a larger loan than 350k to buy the second house valued at 1.85m. Capital gains would take a considerable portion of your profits. Cutting into your profits of both scenarios would be loan interest, property tax, housing insurance, closing costs/brokerage fees and maintenance.
January 31st, 2007 at 5:54 pm
Ryankv: You raise good points, but capital gains wouldn’t be a factor if you reinvest all of the proceeds in your next house. The other factors apply equally or proportionally to both methods, so I considered them moot.
February 24th, 2007 at 1:20 am
The points you make are valid. But the idea is to reinvest property money in order to be tax efficient.
February 26th, 2007 at 1:38 pm
let’s also not forget that IRS caps the capital gains exemption amount to $250k per individual.
April 29th, 2007 at 6:35 pm
Also, if you just pay an extra $200 a month on a $350000 mortgage at 6.259%, you will save over $100000. The problem is that people buy at a price they can barely afford and that’s all right. The first step toward prosperity is to buy your own home.
July 11th, 2007 at 9:37 pm
[...] isnoop.net has a post that gives a good overview of what you might want to look at with regard to the term of your mortgage. Rather than just trying to look into the near future, it’s important to try to gauge how your level of mortgage payments will affect you over the longer term. [...]
August 6th, 2007 at 9:45 am
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October 15th, 2007 at 11:04 am
I am glad that you have given people this information. You here will save people so much money when they buy a home. A mortgage is expensive over the long term, and the interest rate is huge (it adds up).
Many would shy away from a 15 year mortgage, simply due to the higher monthly rate. But it is worth it in the end. After all, every payment you make gives you more equity in the property rather than paying for the interest.
December 9th, 2007 at 1:06 pm
Excellent article! In my experience, most people typically buy a home that they can barely qualify for, which is why they go for the 30 year plan. However, my advice to them is to make an extra payment every year, which will typically pay off your mortgage in 22 years instead of 30 years. This way you get the security of having lower payment obligations when times are tough, but have the flexibility to make extra payments when times are better.