My wife and I were visiting out-of-state friends, recently. We spent a wonderful weekend with them in their lovely home. They told us that they were able to buy the large house for less than what they got for selling their big-city condo. They were in the good position of having money left over after the two transactions.
“I probably should invest the money, but I like having it in the bank,” Stan (name changed) told us. “It helps me worry less and sleep better at night.”
His comment was not surprising. People who have lived their lives without a lot of money in cash reserves find themselves sleeping a whole lot easier with plenty of cash in savings.
Which brings me to the topic of mortgages. I drove by Wichita Federal Credit Union, this morning. Their sign was promoting mortgages. The 30-year rate was 4.5 percent and the 15-year rate was 4.0 percent.
A couple thoughts ran through my mind. First, some of the recent articles proclaiming that mortgage rates were reaching four-year highs and were becoming a potential obstacle to would-be home buyers.
Then, I thought about my first home purchase, many years ago. I financed it at 5.9 percent through Oregon’s GI loan program, several points below the market rate. I remembered how fortunate we were to get such a good deal. Now, four percent is a high rate?
Finally, I wondered why so many people think the 15-year mortgage is a better choice. It usually isn’t.
Isn’t it Obvious?
“Come on, Doug,” you may be thinking to yourself, “It is easy to see why a 15-year mortgage is a much smarter choice.”
Let me help you with your argument. Right off the top, having no mortgage payment in 15 years sounds a whole lot better than making an additional 180 payments.
Of course, the interest rate is a half-point lower, and charged over 15 fewer years. If you were in the process of buying a $300,000 house and planning a 10 percent down payment, the total payments on a 15-year mortgage would be $359,488, which is $133,010 less than the $492,498 you would make on a 30-year mortgage.
It is difficult to argue with the figures. It is, however, a little easier to argue with how it fits into your financial situation and the economic environment we live in.
It’s not just one thing; it’s another…and another
I like to take a big picture look at the decision. Here are a few issues that push me toward recommending the 30-year mortgage:
The payment. At the above stated interest rates, the payments on a $270,000 mortgage are $1,997 for a 15-year mortgage and $1,368 for a 30-year loan. That’s a difference of $629 a month. That money could be allocated elsewhere. During tough times, the smaller payment can be a blessing.
Improved liquidity. Do you have cash reserves equal to six months of your income? If not, use the $629 a month to build them up. Like my friend, Stan, you might just sleep a bit better at night with a larger balance in your savings account.
If disaster strikes. If you do lose your job, your improved liquidity will allow you to make the smaller, 30-year mortgage payment for several months (from cash reserves) before you have to liquidate other investments.
If anything comes up—whether opportunity or emergency—it’s easy to tap your cash reserves. It is not nearly as easy to convert your home equity into cash (especially if the emergency is a job loss).
Progress on other financial goals. Once you have adequate cash reserves, redirect that $629 to investments. If you’re eligible, and not maxing out your employer’s matching 401(k) contributions, be sure to do so. Put money away for college costs, retirement, or other goals.
Debt repayment. Take the 4.5 percent mortgage. Use the monthly differential it to pay off other debts (e.g., student loans, credit cards, autos) that charge much higher interest rates. Once you pay off debts, commit the freed-up payment amount to building cash reserves and investments.
Flexibility. If you started investing the $629 a month and generated an average return of six percent, you would accumulate enough money to pay off the 30-year mortgage in 15 years and 10 months. It’s almost the same result as the 15-year mortgage, except that you have the choice to pay it off…or not.
Inflation is your friend. We can read all kinds of negative things about inflation. However, there is a big positive if you are a borrower. You get to pay the money back with inflated dollars. The reality is that when you reach year 15 and 10 months, that $1,368 may seem a whole lot smaller than it looks today. At a three-percent inflation rate, that payment will be the equivalent of $853 in today’s dollars.
For the reasons listed above, I will usually recommend a 30-year mortgage over shorter-term alternatives (as with any general advice, there are exceptions). If you change your mind, you can use the accumulated investment value to pay off the 30-year mortgage well before 30 years. If you start with a 15-year mortgage, there is no changing your mind.
When is a 15-year mortgage a better choice?
There is one situation where the 15-year mortgage makes sense. When the home buyer has no discipline and is unable to save or invest the difference between the two payment amounts. They might as well attempt to realize the $133k interest savings.
I have learned to appreciate two things in my life: flexibility and liquidity. A 30-year mortgage delivers more of each when compared to the shorter-term (10-, 15-, or 20-year) alternatives. And, like Stan, I always appreciate being able to sleep at night.