15 year vs. 30 year mortgages

A topic you can always find vibrant discussion on is whether you should finance your home with a 15 year or 30 year mortgage. Among the many articles I’ve read on this subject, there seem to be two major opinions: 30 year mortgages offer more flexibility with a lower payment and 15 year mortgages help you eliminate debt more quickly.

Analysis based on inflation

Something that seems rare (only found it in one article) is the discussion of inflation. So I did what any truly independent, active investor should do: I crafted a spreadsheet to analyze both of them including the effects of inflation. The results are surprising.

First off, let’s assume you are borrowing $200,000 at 4%. For a 30 year mortgage, your monthly payment (without taxes and insurance) would be about $954. If you add up all the payments and subtract the original balance, you’ll find that total interest paid on a 30 year note comes to $143,739.01. That is 75% of the purchase price!

Compare that to a 15 year mortgage. Your monthly payment (assuming they are at the same rate) would be higher at $1479.37, which is more than $500 higher. Adding up 15 years of payments and subtracting the loan balance results in total interest of $66,287.65. That is less than half of the 30 year note’s total interest charges. You would be saving about $80,000. Sounds big, right?

Not so fast payoff breath. We haven’t factored in what you can buy with a $20 bill 30 years from now. If we pick a steady annual inflation rate of 3%, then each year, the amount of debt you pay becomes less and less in effective dollars.

The first year of payments on a 30 year note would total $11,457, but in the second year, that amount of money would only be worth $11,124 in today’s dollars. Go on out to year 30, and that amount of money would only buy what $4862 will buy today. Your dollar’s value would decline by almost 60%. If we reduce each year’s payment by 4%, total all those payments, then subtract the original balance, the amount of EFFECTIVE interest you will have paid is only $31,318.65. Inflation will have effectively knocked out $90,000 of that interest.

Let’s compare that to how inflation impacts a 15 year mortgage. The first year of payments will add up to $17,752, but the 15th year will effectively become $11,736. Add up those inflation adjusted payments, subtract the original balance, and you have an EFFECTIVE total interest of $18,286.16. In this situation, inflation has knocked out $48,000 of interest payments.

Bottom line: a 30 year note will reduce your interest payments to $31,000, effectively sidestepping $90,000 in interest. A 15 year note will reduce your interest payments to $18,000, skipping $48,000. The difference between these two is now only $13,000. Are you ready to put down an extra $500 each and every month only to save $13,000 in the long run?

Assumptions

Let me put all my cards on the table. This analysis has a LOT of assumptions.

It assumes inflation is 3% each and every year and is consistent. It assumes you can secure a 4% mortgage and that 15 and 30 year notes have the same rate. I’ve heard that rates have already risen even more than that. The bigger the gap between your loan’s rate and inflation, the more total interest you will save with the 15 year note. You can probably guess that if 15 year notes are a little cheaper than 30 year notes, you can save even more interest.

But if inflation rises in the future, things can quickly shift in favor of the 30 year note. If you had 5% inflation with a 4% note, then the 30 year note would save you almost $10,000 in total EFFECTIVE interest. 6% inflation moves 30 year savings to over $15,000. I’ll let you imagine what happens if we have any form of runaway inflation in the next 30 years.

This analysis assumes you stay in the same home over the life of the loan. Banks have studied how long loans last, and the average appears to be 2-7 years. That’s why they add extra fees if you want to reduce the interest on your loan. They know you probably won’t stay long enough to realize the savings and are locking in their profit.

Risk vs. Reward

Why do banks want to encourage you to take a 15 year note? After all, they tend to offer slightly lower rates for 15 year mortgages. In fact, I can remember seeing a giant banner at my old bank that bragged “save over $100,000”.

Banks aren’t stupid; they do things that serve their best interests. What is the advantage to them? Basically, they get their capital back sooner rather than later. The faster you pay off the balance, the faster they gather their profit and get recapitalized. And since this article is focused on inflation, they prefer getting their money in today’s dollars rather than tomorrow’s devalued dollars.

Always remember that fixed debt favors the borrower in times of inflation, because future payments are always worth less. In fact, in one article, someone commented how his father once had to work two jobs to afford a $3000 mortgage he had taken out decades ago. But towards the end of the loan, his monthly payment was in the range of $98 and he liked to brag about it!

The faster you pay off the balance, the more liquid the bank is and the less liquid you are. You are pouring lots of equity into the walls of your house, which you can’t eat or generate cash flow. But the bank CAN generate cash flow by using your payoffs to lend other people money.

Math vs. Psychology

There is another dimension to this analysis. You can crunch numbers all day, but many people flat out don’t want debt. They detest 30 year mortgages, and thanks to the huge upswing from the anti-debt crusaders, they feel strengthened to take out a 15 year mortgage. They are happy to be ten years in, with only five years left to go, and celebrate the fact. They want to enter retirement with no debt. In fact, they are happy to point out how they “must have done something wrong” in a jesting style when they approach the time frame and having paid off their mortgage.

I would like to enter retirement with no debt either, but I would prefer to carry debt if it meant I had more cash flowing wealth. After all, true financial freedom isn’t being debt free. It’s when you have enough solid cash flowing assets such that you can pay off all your debts if you had to, but you simply choose not to. Being house rich and cash poor is not a good way to live your retirement. People that enter retirement with little income tend to end up working at Walmart or taking out expensive reverse mortgages.

I think I’ll stick with my 30 year 3.625% mortgage and let it ride.

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