With interest rates at record lows, many Americans must determine whether to pursue a 15-year or 30-year mortgage term. There is a common misconception that a 15-year term is the best financial decision. Could it be? Perhaps; but there is no one-size fits all answer.
When our ELP Budgeting Services clients ask us to advise on the best term, we do not simply provide an opinion. Instead, we consider the numbers. What’s the saying? “Banks lie, brokers lie, but numbers don’t lie” or something like that. We scrutinize each client’s budget, financial plan, current savings, and investment strategies. For more than 95% of our clients we recommend the 30-year term.
Consider the example above. In the first scenario, the mortgage term is 15 years at 2.625%. Megan’s mortgage of $2,354 does not allow room in the budget to simultaneously invest. At the end of 15 years she’s paid $423,794 over the life of the loan. While it’s true she owns the home as an asset, the home itself is not liquid cash and her net income flow is -$423,794.
We know what our tricky readers are now thinking. “Okay so I will pay my house off in 15 years and then invest that total mortgage amount for the next 15 years.” These calculations are represented in scenario 2. Let’s assume Shirley’s 15-year term mortgage at 2.625% is also $2,354. She also will have paid $423,794 over the life of the loan. Like Megan, Shirley cannot afford to invest while paying the mortgage. Shirley is more disciplined than Megan. For the next 15 years after the home is paid off, Shirley invests the $2,354 and earns a 7% annual return. After 15 years investing, she will have earned $732,341. Her net increase is $308,547. Not too shabby.
In scenario 3, Anthony opts for the 30-year term with a higher interest rate at 2.875%, but his monthly mortgage payment is only $1,452. Anthony invests the $902 monthly savings, as compared to Megan and Shirley, for 30 years. While he will have paid more over the life of the loan at $522,765, his 30-year 7% return on investment yields $1,054,846. Anthony’s net increase is $532,081!
Have we convinced you that a 15-year mortgage is not always financially advantageous?
Multiple variables can yield a different outcome for each household.
Here’s a list of 3 Budget Saving Mortgage Considerations to decide which mortgage term is best for you.
1. Will a 15-year payment account for more than 25% of your budget?
Even with a lower interest rate, a 15-year monthly payment will be higher than a 30-year term. If a 15-year mortgage monthly payment will account for more than 25% of your net income, steer clear of the 15-year term. Avoid being “house-poor” and allocating more than is affordable to housing. Future increases in property taxes and insurance rates can result in even higher monthly payments. Go for the 30-year term if you are in need of a more budget-friendly payment.
2. Will your budget allow for additional investment avenues in a 15-year term?
If you answered no to consideration number two, ELP Budgeting Services still doesn’t give the green light for a 15-year term. We want to know that our clients will be able to invest while paying the 15-year monthly payment. As we showed in our examples, time plays a big factor in investment returns and compound interest. If the 15-year term is technically budget friendly, but chews up the investment budget, consider opting for the 30-year term.
3. Will you budget your 30-year monthly savings towards investing?
In the scenarios above, we proved that the benefit of a 30-year lower monthly mortgage results strictly from the ability to invest. If the monthly savings are not invested, a 30-year term is not financially advantageous. Choose a 30-year term if you will invest the savings and/or if the monthly payment accounts for 25% or less of the budget.
Perhaps a 30-year term is the most budget friendly but does not allow for additional investing. Don’t stress it! Allow ELP Budgeting Services to run the numbers through an Affordability Analysis. From there we will develop a personalized budgeting strategy to create a path for investing and generational wealth.