Mortgage Term: 30 Years or 15?
February 22, 1999, Revised November 24, 2006, October 25, 2007
For those who can afford the higher payment, the 15-year mortgage builds equity much more rapidly than a 30, reflecting both the shorter term and a lower interest rate. Many borrowers who take a 30 and make extra payments, would have done better with a 15. Those who take a 30 to invest the cash flow difference have to earn a high return to make it pay.
"We can afford the payment with a 15-year mortgage at 6.75%, but the 30-year at 7% will give us more flexibility. What do you think?"
Borrowers who have the luxury of choosing between 30 and 15-year terms must decide whether they are payment-minimizers or wealth-maximizers. The first group is concerned mainly with the present, the second with the future.
The mortgage payment on a $100,000 30-year loan at 7% is $665 while on a 15-year loan at 6.75% it is $885. The lower payment on the 30 is certainly attractive.
On the other hand, after 5 years the borrower who took out the 15-year loan has repaid $22,933 while the borrower who took out the 30 has repaid only $5,868. That amounts to a difference in wealth accumulation of $17,065. To me, that’s even more attractive; I’m a wealth-maximizer.
The Flexibility of the 30 May Prove Illusory
The "flexibility" that you mention as the advantage of the 30-year loan is really the freedom to spend the difference in payment on other things. Yet I am amazed at how many borrowers elect the 30-year option to obtain this freedom, then find that they really don’t want it after all! After a few years of being homeowners, they discover that what they really want is to build equity more quickly than the 30 provides. They discover, in other words, the relevance of the future.
At this point some of those who took out 30-year loans begin systematically making additional monthly payments to build equity faster. Of course, they would have been better off taking the 15-year at the outset and enjoying the lower interest rate, but better late than never.
Some of these restive borrowers are not able to muster the self-discipline that a voluntary savings plan requires. These are the ones who are attracted to the biweekly payment plans that are offered by many lenders and third party vendors. Under a biweekly plan, instead of one monthly payment, the borrower pays half the monthly payment every two weeks. This results in 26 payments a year, which is the equivalent of 13 monthly payments instead of 12. The extra payment every year builds equity faster.
Since the biweekly involves a contractual commitment by the borrower, it provides a discipline that the self-designed plans do not have. The borrower pays for this discipline in the form of an up-front fee and in lost interest on the accelerated payment. These are additional costs the borrower could have avoided by taking out the 15-year loan at the outset.
There is one situation where a wealth-maximizing borrower who can afford the payment on a 15-year might nevertheless select the 30. A borrower with attractive investment opportunities, such as a family business or the stock market, might select a longer term and invest the difference in the mortgage payment in high-yield investments. This is the possibility referred to in the letter that follows:
"I have decided to take a 30-year loan rather than a 15 because I can invest the difference in payment at 10%. Since I am only paying 7% on the 30…I must end up ahead. Is there anything wrong with my logic?"
Your logic would be sound if the interest rates on the 30 and 15 were the same. But since the interest rate on the 30 is higher, you have to stay with it long enough for the high earnings on the difference in the payment to offset the loss from the higher mortgage rate.
The table below shows the return you need to earn by investing the payment different between the 30 and 15, just to break even. To come out ahead, you must earn more. The required return is higher if the rate difference between the 30 and 15 is .5% rather than .25%, and it is higher when the down payment is smaller because mortgage insurance premiums are larger for 30s than for 15s. These numbers are from my calculator 15b, Mortgage Term Calculator: Investing the Cash Flow Savings on a Longer-Term Mortgage.
Not only do you need patience if you take this route, but you must have confidence in your investment acumen – low-risk investments that yield 10% or more are not easy to find. In addition, you need the self-discipline required to invest the difference in payment each and every month. If you don’t have the required patience, confidence or discipline, take the 15-year loan.
For further discussion, see Is There a Yield on a Shorter Mortgage Term?
For those who can afford the higher payment, the 15-year mortgage builds equity much more rapidly than a 30, reflecting both the shorter term and a lower interest rate. Many borrowers who take a 30 and make extra payments, would have done better with a 15. Those who take a 30 to invest the cash flow difference have to earn a high return to make it pay.
Longer Terms Reduce Payments, Shorter Terms Increase Wealth
"We can afford the payment with a 15-year mortgage at 6.75%, but the 30-year at 7% will give us more flexibility. What do you think?"
Borrowers who have the luxury of choosing between 30 and 15-year terms must decide whether they are payment-minimizers or wealth-maximizers. The first group is concerned mainly with the present, the second with the future.
The mortgage payment on a $100,000 30-year loan at 7% is $665 while on a 15-year loan at 6.75% it is $885. The lower payment on the 30 is certainly attractive.
On the other hand, after 5 years the borrower who took out the 15-year loan has repaid $22,933 while the borrower who took out the 30 has repaid only $5,868. That amounts to a difference in wealth accumulation of $17,065. To me, that’s even more attractive; I’m a wealth-maximizer.
The Flexibility of the 30 May Prove Illusory
The "flexibility" that you mention as the advantage of the 30-year loan is really the freedom to spend the difference in payment on other things. Yet I am amazed at how many borrowers elect the 30-year option to obtain this freedom, then find that they really don’t want it after all! After a few years of being homeowners, they discover that what they really want is to build equity more quickly than the 30 provides. They discover, in other words, the relevance of the future.
At this point some of those who took out 30-year loans begin systematically making additional monthly payments to build equity faster. Of course, they would have been better off taking the 15-year at the outset and enjoying the lower interest rate, but better late than never.
Buying the Discipline to Increase Payments
Some of these restive borrowers are not able to muster the self-discipline that a voluntary savings plan requires. These are the ones who are attracted to the biweekly payment plans that are offered by many lenders and third party vendors. Under a biweekly plan, instead of one monthly payment, the borrower pays half the monthly payment every two weeks. This results in 26 payments a year, which is the equivalent of 13 monthly payments instead of 12. The extra payment every year builds equity faster.
Since the biweekly involves a contractual commitment by the borrower, it provides a discipline that the self-designed plans do not have. The borrower pays for this discipline in the form of an up-front fee and in lost interest on the accelerated payment. These are additional costs the borrower could have avoided by taking out the 15-year loan at the outset.
Investing the Cash Flow Savings on the 30
There is one situation where a wealth-maximizing borrower who can afford the payment on a 15-year might nevertheless select the 30. A borrower with attractive investment opportunities, such as a family business or the stock market, might select a longer term and invest the difference in the mortgage payment in high-yield investments. This is the possibility referred to in the letter that follows:
"I have decided to take a 30-year loan rather than a 15 because I can invest the difference in payment at 10%. Since I am only paying 7% on the 30…I must end up ahead. Is there anything wrong with my logic?"
Your logic would be sound if the interest rates on the 30 and 15 were the same. But since the interest rate on the 30 is higher, you have to stay with it long enough for the high earnings on the difference in the payment to offset the loss from the higher mortgage rate.
The table below shows the return you need to earn by investing the payment different between the 30 and 15, just to break even. To come out ahead, you must earn more. The required return is higher if the rate difference between the 30 and 15 is .5% rather than .25%, and it is higher when the down payment is smaller because mortgage insurance premiums are larger for 30s than for 15s. These numbers are from my calculator 15b, Mortgage Term Calculator: Investing the Cash Flow Savings on a Longer-Term Mortgage.
Required Rate of Return
| Mortgage Features | 5 Years | 10 Years |
| Rates on the 30/15: 6.75% and 7% | ||
| 20% Down | 10.13% | 8.3% |
| Zero Down | 14.13% | 12.10% |
| Rates on the 30/15: 6.5% and 7% | ||
| 20% Down | 13.32% | 9.64% |
| Zero Down | 17.5% | 13.6% |
Not only do you need patience if you take this route, but you must have confidence in your investment acumen – low-risk investments that yield 10% or more are not easy to find. In addition, you need the self-discipline required to invest the difference in payment each and every month. If you don’t have the required patience, confidence or discipline, take the 15-year loan.
For further discussion, see Is There a Yield on a Shorter Mortgage Term?