- Kevin McCollester
15 yr mortgage
Updated: Oct 16, 2019
Ask almost anyone and they will say that a 15 yr mortgage is better than a 30 yr mortgage. It seems to be conventional wisdom. In fact, conventional wisdom would tell us to take out a mortgage for as short a term as possible and pay cash for your home if you can. The reasons are usually listed as follows:
You'll pay less interest
You'll own your home sooner
Since your home is usually the biggest debt we incur in our lifetime, paying it off generally equates to getting out of debt, and that's a good thing
And besides, who wants to be paying a mortgage as you enter retirement?
I'm sure there are other reasons, but if I can ask you to indulge me for just a few minutes, I'd like to challenge this "wisdom" with some real numbers and by asking a question or two.
First, a question. No doubt you have heard of Dave Ramsey. He is a champion of getting out of debt, living within your means, paying cash, saving as much as you can in qualified plans (401k & IRA), the 15 yr mortgage and buying term life insurance. In fact, Dave is emphatic that you should "buy term and invest the difference". This is because he believes you can get 12% average return on your money by investing in good mutual funds. So essentially Dave is telling you to buy the life insurance with the lowest payment so you can invest the difference between what the same amount of permanent insurance would cost and what you pay for term insurance. If you do this and earn 12%, you'll never have to worry about money in retirement. But when it comes to buying a house, he recommends paying cash or putting 20% down and financing with a 15 yr mortgage. But, if you pay cash for a house, you no longer have that money available to invest in good mutual funds earning 12% per year. Does real estate go up by 12% per year on average? Not hardly. It is hard to get good numbers on real estate appreciation because there are so many factors; type of house, age of house, city and state of house, local economy, national economy etc., but I think it is safe to say that "average" real estate appreciation over the last 50 years has been in the 3 - 5% range. So by paying cash, you are giving up the opportunity to make 12% to make 5% instead. I don't think we would normally consider that a good trade. But what difference does it really make? A $250,000 house appreciating 5% per year for 30 years becomes a house worth $1,080,485!! But $250,000 in good mutual funds earning 12% per year ends up being $7,489,980!!! That's a difference of $6.4 Million dollars!! BUT ... by paying cash, you have money to invest that you didn't have before. Doesn't that cancel this out? Let's find out.
Let's look at 3 conventional scenarios and see which one results in the most money.
All 3 scenarios will use the following:
5% per year appreciation
12% per year earning in mutual funds
15 yr fixed mortgage rate = 4%; P&I = $1500 / month = $18,000 / year
30 yr fixed mortgage rate = 4.5%; P&I = $1025 / month = $12,300 / year
timeframe = 30 years
Scenario #1 - Pay cash and invest the unnecessary mortgage payment
Scenario #2 - 20% down, 15 yr mortgage, invest $200,000 and invest mortgage payment for last 15 years
Scenario #3 - 20% down, 30 yr mortgage, invest $200,000 and invest difference between 15 and 30 yr mortgage for 30 years
Notice that the house appreciates the same in all 3 scenarios. Home appreciation doesn't care how much you owe. So which scenario is best? If you purely look at numbers, the best case scenario is the 30 yr mortgage, exceeding paying cash by over $2.5 Million and outperforming the 15 yr mortgage by over $600,000 - not including the possibility for a greater mortgage tax deduction and the fact that the risk of default is lower since the monthly payment is nearly $500 less.
We all know that life gets in the way and actual performance will NOT match the chart above. And we know that paying cash for a house is not realistic for most people, but choosing between a 15 year and a 30 year mortgage is something we all should consider and not just assume that a 15 year mortgage makes the most financial sense.
So let me ask you this. Why does Dave Ramsey advocate the 15 year mortgage and not "30 yrs and invest the difference"?? The 30 year mortgage is the lower payment product, just like term insurance. Is it possible that he doesn't really think you can get 12% in the market? Seems kind of curious to me.
Please let me know if you'd like to discuss this or how you too can "think differently" about money.