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Is a 15-year Mortgage For Everyone?
| January 25, 2011 | Posted by Roshawn Watson under Uncategorized |
By: Roshawn Watson
There are few decisions that will likely impact your finances more than the place you choose to reside. If your house is your biggest investment, that typically IS the problem. That’s because few purchases will impact your cash flow as much, and your income is your most powerful wealth-building tool. Unless your family has (or will have) a substantially large sum saved for this purpose, you will likely have a mortgage. Unfortunately, some have learned the pitfalls of adjustable-rate and balloon mortgages first-hand; however, under what circumstances should someone avoid even a 15-year fixed mortgage?
Mortgage Debt Is Different
Mortgage debt (on a primary residence) is practically the only debt that even some of the most financially-conservative advisers and commentators will approve. It differs substantially from credit cards and student loans in that it is secured by the value of the asset. Presumably, it differs from car debt as well because cars rapidly depreciate, and homes generally don’t and even have the potential to appreciate (especially over the long term and in good neighborhoods). Plus, you can get money out of your home by selling it; also, you have to live somewhere anyway. Despite these distinctions, a mortgage is still a debt and can wreak significant havoc on your finances if not handled properly. If you doubt this, just ask these financial elite.
Should the Mortgage Be 15 or 30 Years?
It’s is amazing how much mortgage brokers will pre-qualify you for, despite the tighter lending standards. There’s a reason why they call them brokers: the wrong one can make you broke! However, their loose standards should not be the primary determinant of your housing budget. Remember, their primary ambition is to sell you debt for a profit! My concern is that you make that profit. Some ways to make sure that you haven’t financially overextended your family are to make sure that you meet the following minimal guidelines:
- Principal, interest, taxes, homeowners associations dues, and insurance should not exceed more than 25% of your net (take-home) monthly income on a 15-year fixed mortgage
- The mortgage is no more than 3 times your annual household income (2 times if you are especially conservative).
- You are free of all consumer debt (including student loans, car note, credit cards)
To do this requires a measure of delayed gratification that many people do not possess nor aspire to have. Also, there are some real estate markets where meeting these criteria will be more challenging. Yet, following these guidelines would allow most people to hit their other main financial goals (i.e. retirement and college funds, giving, paying off the mortgage early, and other investing) with such an uncommon vigor and power that few will ever truly experience.
Imagine what it feels like to be able to have the freedom to invest thousands on a monthly basis!
The rationale for a 15-year fixed mortgage are numerous, even at today’s ridiculously low rates. First, choosing a shorter term usually means you’ll get a better rate, so you’ll pay much less interest over the life of the loan. Let’s look at an example: if you borrow $200,000 (on a $250,000 home) on a 30-year fixed mortgage, then your monthly payment is $1081 at the present interest rate is 4.81%, and you’ll pay a total of $389,160. However, if you borrow $200,000 on a 15-year fixed, your monthly payment is $1479 at the present rate of 4%, and you’ll pay only $266,220. Thus, you’ll save $123,000 in interest just by going with the 15-year mortgage because you cut the life of the loan in half and pay a lower interest rate. If you don’t think $123,000 is significant, then just write a check for $123,000! It bothers me that most people do not give thought as to how they are going to replace that $123,000 when they opt for 30 year loans? Second, paying a 15-year mortgage instead of a 30-year mortgage indirectly acts as a forced savings mechanism. You’ll simply pay more principle faster throughout the loan. Of course, the end goal is to invest so that you can build some real wealth. Third, 97% of people do not systematically prepay their mortgages. This is important because this means that the people who truly execute “paying a 30-year mortgage as a 15-year mortgage” are few and far between. Fourth, since you will finish at least 15 years earlier, imagine how much you can invest once you no longer have any debt payments!
The Small Mortgage Invest The Rest The Rest Strategy
The Wall Street Journal wrote an article that contrasts the outcomes of buying a $1 million home as opposed to a $400,000 home and investing the balance (in mutual funds). The author found that in the long run, the “small house, invest the rest” strategy is far superior to the “big house” strategy financially speaking.
[Y]our portfolio would be worth $2 million in today’s dollars…almost twice what you would pocket with the “big house” strategy. With the “big house” strategy, not only would you face hefty mortgage payments, but…also…(higher) property taxes, maintenance costs, homeowner’s insurance and utility. However… you would live in a grander place but that just highlights what this is all about. Buying a bigger house isn’t an investment. Rather it is a lifestyle choice, and it comes with a brutally large price tag.
Back In Vogue
Did you know that 15-year mortgages are coming back in style among those who refinance?
CoreLogic reported that the 15-year fixed-rate mortgage made up 9.4% of the refinanced mortgages in 2007, 18.5% in 2009, and 26% for the first part of 2010 (January through June). There is clearly an upward trend! Homeowners choosing the 15-year fixed mortgage typically share the following characteristics:
- they prioritize paying off debt
- they see the risk in viewing their mortgage as part of their investment portfolio (using the mortgage as leverage to invest)
- they are typically older and don’t have some of the same expenses as their younger counterparts
- they typically have a higher income and higher equity.
Remember,15-year mortgages pay off in 15 years every time (assuming you didn’t take money out of the home or prepay). Additionally, almost 100% of foreclosed homes have mortgages, so the sooner you get rid of yours the less likely you are to be foreclosed on. If you choose to get a mortgage, why not do so in a way that is the least risky? After all, I’m absolutely certain that you could find a better use for that $123,000 than your mortgage company anyway!
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I had a 15 year mortgage when I had a mortgage. The prospect of paying less interest to the bank and more principal with each payment was very appealing. The tax deduction for mortgage interest is way overrated.
I concur wholeheartedly! You and Money Reasons are great for paying off your mortgages!
I had a 30 year fixed and made an extra principal payment each month which allowed me to pay it off early. I agree with the Grouch about the tax deduction. Unfortunately I see a number of people who want to retire but still have a hefty mortgage balance. In many cases this complicates matters greatly.
Interesting post but for most people I think a thirty-year mortgage (30M) would strike a better financial balance. However, to make a 30M the financial tool it can be, it needs to be managed correctly. Unfortunately, that will seldom happen but that is not a reflection of the value of the tactic (30M) but, rather, more like human nature and societal realities.
If one could stay in one house for the term of the 30M, then the benefits of thirty-year financing begin to accrue. But, on average, we tend to move every seven years and, many times, when we buy at our new location the average tendency is to finance a more expensive house with a new 30M.
When you do that, you start all over again and in the most expensive portion of a 30M—the first ten years when almost all of your payment is interest.
So, if you could plan to stay put for at least fifteen years, you could obviate the downside of human nature and societal trends and pay off your mortgage. And it is more likely that you can stay in just one house for fifteen years than thirty; so, in that sense, at least, maybe a 15M is, in fact, the way to go.
Good post!
This is absolutely correct. The fact that the vast majority of people do not systematically prepay their mortgages is a tragedy, yet an accurate reflection of what we are dealing with. The problem is by the time people are ready for retirement, they have often paid hundreds of thousands of dollars in interest with little to show for it, except for an asset. This isn't a great financial move.
Kudos to you for such an insightful comment. Human nature is a big factor with personal finance. It is my belief that 80% of personal finance is human nature. If we were logical, who would sign up for consumer debt to begin with? Mathematically, if people factored in risk and taxes, the spread between investing in the paper assets and the guaranteed return of paying a mortgage is not as big as people think.
Again, as you say, people are going to move anyway, so being able to move with more of your money (principal) would make a lot of sense.
Thanks again for such an interesting comment!
I agree with "The Biz of Life", especially on lower mortgage loan amounts. That said I start out with a 30 year loan, paid extra principal payment on it, then alter after the interest rates dropped, switched to a 15 year loan (free closing cost from Wells Fargo), and then made extra payments on that loan too. So my mortgage was paid off in just a few months over 10 years.
We just bought a modest sized house because my wife was going to be a SAHM… It worked out well for us so far. Throughout this time, I still contributed around 10% into a 401k and even put a little money into a 529 too. Money was always tight, but we hoped it would be worth it in the long run. Now a good chunk of our money is going into investments and the story is still unfolding…
We got a 15 years mortgage for our first home and that was a great move. After 10 years and a couple of refinance, most of the payment are now going to the principle.
I think 30 years loan is a good idea for real estate investment like rental. With the smaller payment, you stand a better chance of having positive cash flow. The rent will go up over time and you can put some of that back into the principle as needed.
Don,
10 years is a ton better than 30 years (or longer)! For your temporal sacrifice and the decision for your wife to be a SAHM, you have placed yourself in a very enviable position: to be completely debt free and able to invest a sizable chunk of your income each month. Over the long-term, I think you made the decision to be really wealthy!
You are making an interesting distinction on a primary residence versus rental investment. As a rental property investor, what do is the biggest threat to your cash flow?
I refinanced my home roughly eight years ago with a 15 year mortgage. I wanted to make sure it would be paid off by the time I retire. I notice there are more products with shorter time periods available now. It is a good trend!
It depends. You shouldn't take on more than what you can chew. And you can always pay off your 30 year loan in 15 years if you so choose (assuming you don't have pre-payment penalties).
I agree that it is definitely a very good trend. People are discovering that they don't have to be in debt forever and can benefit even from a slightly more aggressive payment schedule.
I know where you are coming from. If someone already has a great rate or can't refinance, I definitely think paying a 30 year as a 15 year is a good option. The only problem that I see with this for many people is behavioral. Fewer than 1 in 20 will systematically prepay a mortgage. Rather than taking on more than you can chew financially by getting a 15-year mortgage that one cannot afford, I would rather delay the purchase personally.
That is actually a good point! If 401K payments were voluntary I can imagine how many would actually have anything saved up for retirement! (dumb analogy I know, but that's what was going through my mind as was typing a response!)
Not a dumb analogy… I get it. It makes sense that they have that control on 401Ks; otherwise, something else would generally come up. People already dip into 401Ks too often, but suppose we weren't penalized and taxed? These behavioral controls have a big impact. It's kind of like the Automatic Millionaire by David Bach 🙂 Taking the guess work out of financial plannings yield better results generally speaking.
"The mortgage is no more than 3 times your annual household income (2 times if you are especially conservative)." Do you know how many people actually adhere to this rule?
We started with a 30 year and only did modest prepayment (rounding to the nearest 000). Then we did a no-fee refinance to another 30 year (15 and 30 year rates were the same that day). Then we did a no-fee refinance to a 20 year (we wanted 15, but they wouldn't give it). Then we started aggressively prepaying. We have 11.8333 years left on the mortgage and have been living in the house for 4.5 years. I don't know how much more we'll be pre-paying… other investments are starting to look more attractive. We'll see. In the next couple of years we'll know more about our future long-term plans.
That's actually a great question. The 3 times your annual household income rule is actually pretty standard. Most personal finance books and mortgage brokers say not to let your principal, interest, taxes, and insurance exceed 28% of your monthly income. (The real danger zone is when your total debt to income ratio exceeds 35%). If you can satisfy this rule, you can generally satisfy the mortgage less than 3 times your annual income rule as well.
If you have the median US household income of $50,000 per year. That means your take home about $3125 monthly. The target home value would be less than $150,000. If you choose a $120,000 home with a $100,000 mortgage, your monthly payment on a 15 year fixed would be just $739 (assuming 4% APR). This would be well within those guidelines. Of course, you can play with the numbers, but this rule of thumb sometimes calls for delaying home purchases until you can put more down, buying less home, or moving further away from the city. That's quite a sacrifice, but the benefits are that you are not house poor, can actually build substantial wealth, and can pay the home off earlier.
Most people don't do the home mortgage less than 2 times their income; this strategy is more common among millionaires and those who desire to become millionaires.
We bought our house with a 30 year mortgage (not sure why, we could have afforded a 15. Probably because I was a SAHM and we needed liquidity.) However, rates started plummeting and we refinanced for 15 year loan, and it was only a few hundred extra a month since the rate was so much lower. So, we have 7 more years on the loan, but it will be gone sooner than that. I love how my equity is just dropping!
This sounds great! That's how the process is suppose to work, and I wish more people were as responsible and prosperous as you. If we were going to stay in our home, we would probably pay it off in 2 years or less (so far, I have had it for 4.5 years). Alas, I know it will ultimately be on the market, so while we do pay extra (kill principal), we will just roll the equity into our next home and aren't stressing about finishing it (anti-climatic, no?)
Kudos to you and your husband for tackling that mortgage!
We under-bought in terms of house vs. income, and haven't moved in 10 years. We refinanced for 30, but will not likely stay in this house past retirement — or sooner, depends when the kids move out. Hopefully sooner, the HOA fees are bugging me more and more every year.
Andrew,
Underbuying probably feels pretty good right about now when people have been struggle around. That's one of the great things about being responsible: when things sometimes go sour, you look like the genius you are :).
If your HOA fees are anything like ours, they consistently go up without any change in service and have special assessment a little too often. They certainly know the meaning of inflation LOL!
Cheers!
The most important thing is to keep the place rented out of course. 🙂
Keeping the monthly fixed cost down is also very important hence the 30 years mortgage.
A 15 year is great if you plan to live there for 15 years.
What mortgage do you have Roshawn?
This makes perfect sense to me!
Agreed Sam. I think 15 years should be the longest we should plan on having it. Early payoff is always an option.
We have a 30-year fixed; if we weren't planning on selling our place, we would have refinanced to a 15-year; however, we are way ahead of schedule with respect to repayment. If we stay in our current place, the mortgage would have been paid off in a total of 6.5 years or less.
I did almost exactly what money reasons did with the same outcome. Start with 30 until you're comfortable paying the extra and then when you refinance to a 15 your payments almost don't change because you've paid down some of the principle already. We paid our house off in 10 years.
Sandy, I'm so proud that so many of you (Money Reasons, Biz of Life, DIY Investor, etc) have taken the plunge and paid off your homes. That's pretty rowdy, especially in this "I want it now culture". Kudos, kudos, kudos.
10 years is really quick, and I'm very happy that it worked out for you so well! Now you have that fabulous income and NO MORTGAGE! That's definitely an enviable position to be in!
Thanks. It helps that the house I bought was cheap and small and was a dumpy fixer. It's nice now though.
I'm not mortgage free yet. I still have my second mortgage (the house my mom lives in) that I'm now doubling up on so it doesn't feel like I have any extra cash flow just yet because it's all going into the second house. It'll be so liberating once I'm 100% debt free and hopefully it'll be very soon.
I hope so, I have personally sacrificed along the way. Barring bad luck, I expect things to speed up with wealth accumulation. I also expect to enjoy spending money a bit more too… I won't spend money on bottles of Cristal, but a bottle of inexpensive but quality-in-taste wine is now part of my buying habits.
I'm glad that you are dumping the second mortgage. I'm always amazed by what happens financially when I look at the impact of doubling a house payment on an amortization table.
Good luck with being 100% debt free
You absolutely have to remember to enjoy your wealth too. Being a miser is not fun and leads to regret and fear. That's certainly not my definition of winning with money either.
Good one Roshawn….God, I love a 15 yr mortgage…until this house, it was my standard, but with some increased financial uncertainty since the divorce, I could not commit this time & reluctantly went with the 30 yr….but am hopeing to be able to refi before the rates start kicking up again.
I recently heard a great podcast on NPRs Planet Money about the most crazy, dangerous mortgage out there….which (shocking to many) is not the some crazy negative amort/ no doc / no payment ARM, it's the 30 year fixed! Find it on itunes, or google it, it was very interesting! Keep up the great work!
Great point about planning to have home paid for by retirement. This seems obvious, but is often overlooked when deciding the loan term. A 50 year old taking out a 30 year loan, for example, is someone who is not planning for retirement.
I think the right way to compare the two loans is not the total interest paid to the bank but the total interest paid to the bank when comparing apples to apples. So take a 30 year mortgage and pay the 15 year mortgage amount and see how much difference you would pay. My guess it would be maybe 10 or 20K more in interest (using your numbers above) – I'd happily pay that extra 10 or 20K to know I have some wiggle room in my budget for 15 years….
We were in a very similar situation (rounding to the nearest 000 as well on a 30-year fixed initially but started paying it as a 15-year fixed; mortgage is on track to be paid off in less than 15 years). I can certainly understand how other investments are looking more enticing. We have been pouring money into the market too (while aggressively paying down). It's a balancing act not a contest 🙂 Regardless of what you will decide, I'm sure it will reflect not only sound judgment but also what's best for your family.
This is so practical, like you said, but one of the reasons why things like this need to be verbalized/written down is because "common sense doesn't appear so common."
Even if you don't want to stop working, one day you may be forced to (if for nothing but your employer may not want you around anymore). It's a disservice for most people to have a mortgage at that stage in life?
Thanks so much Chris! I do hope you will be able to refi while rates are near historic lows!
That's quite an interesting commentary for the 30-year mortgage. I'll have to hunt down that podcast this weekend. I obviously am not a huge fan of the 30-year because it keeps people in debt for too long
Evan,
That's another way to think about it. I'm not a fan of keeping debt around for extended periods of time anyway, so I'm naturally biased against the longer terms. That said, I understand your justification, but I think the cash flow constraints and increase risk don't make keeping the mortgage around a great choice for me personally.
In Canada, things work a little differently — amortization periods can be 15, 20, 25, 30, and 35 years, and I believe 5 and 10 years as well. The mortgage itself is renewed every 5 years, so even with a fixed rate your rate will only be locked for 5 years. There is also a 10 year fixed but the rate premium is obscene (the 5 year premium can already get excessive).
There is also a 5 year variable which is what I have opted for, since the difference is a good 2% and I don't think rates will rise fast enough in the next 5 years for fixed to have been worth it.
Canadian mortgages are also generally open which means you can pay up to 25% of the balance in any given year and prepay between 25% and 100% of the monthly payment in any given month. The terms will vary from bank to bank, and these payments are supposed to be applied directly to the principal.
My recent post Stocks Are Far More Risky When Valuations Are High
Exactly, I agree with it. The main reason behind this is the huge majority of people who do not methodically prepay their mortgages are disaster; however a precise sign of what we are trading with.
Many countries have a notion of standard or conforming mortgages that define a perceived acceptable level of risk, which may be formal or informal, and may be reinforced by laws, government intervention, or market practice.
The amount of capital included in each payment varies throughout the term of the mortgage. In the early years the repayments are largely interest and a small part capital. Towards the end of the mortgage the payments are mostly capital and a smaller portion interest.
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Recent economic issues have forced mortgage rates to decline, therefore buying a home is a very attractive option for those who can take advantage of the low rates. Locking in a fixed rate means that your mortgage payment will not increase for the life of the loan. Thank you.
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