Perhaps you have heard the argument that it makes sense to take out a 30-year mortgage instead of a 15-year mortgage because you can invest the difference between the two payments in an effort to maximize your wealth. This is especially common in a low interest rate environment where you can borrow at low rates. There are a few basic points to this argument:
- The interest paid on the mortgage is tax deductible
- Over time, you can potentially earn a higher rate of return than you are borrowing at
- You aren’t locking your money up in the equity of your home
We want to address these points using the hypothetical situation of John and Jane. They have the option to borrow $200,000 for 30 years at a fixed rate of 4.5% ($1,013 monthly payment) or 15 years at a fixed rate of 4.0% ($1,479 monthly payment). We’ll assume they are in the 25% marginal income tax bracket, 15% capital gains tax bracket and can earn 6% on their investments. Before revealing the results of the comparison, let’s take another look at the key points in favor of the 30-year and invest strategy.
Interest Rate Deductibility
Mortgage interest remains deductible under the Tax Cuts and Jobs Act (for mortgage debt up to $750,000), though home equity loan interest is no longer deductible. However, with the standard deduction greatly increased, many people will no longer be itemizing.
Due to the Tax Cuts and Jobs Act, the interest rate deductibility argument (point #1) no longer applies for many people. To make our example as fair as possible, we will assume John and Jane are able to itemize and that the additional tax savings they receive from the 30-year loan instead of the 15-year loan would also be invested each month.
Rate of Return
For our example we’ll use a rate of return of 6%1. The higher the rate of return assumed, the better the 30-year and invest strategies results are. However, with a higher assumed rate of return comes more risk. Since the argument in favor of the 30-year and invest strategy only requires a return greater than the mortgage rate (point #2), we’ll seek to do so with as little risk in the investments as needed. Our model for comparing the two scenarios assumes a linear return (no variability in the return) of 6%. Investing in the real world would introduce volatility and other risks, most importantly, sequence of return risk. The nuances of these points are beyond the scope of this post. Just be aware that the assumptions used in the model are more favorable for the 30-year scenario than the 15-year scenario.
Equity Built Only in Your Home
We believe that deciding between a 30-year or 15-year mortgage is a financial planning question. There are many financial planning questions that should be addressed prior to this question, including emergency funds, managing cash flow and investing towards your goals. Since we would put other planning issues prior to the mortgage question, we dismiss the complaint about locking money up in the equity of the home (point #3) as irrelevant.
We’ve created an Excel file that models out both of the loan options and includes all relevant details such as also investing the tax savings on the larger interest payments under the 30-year scenario and taking into consideration the capital gains tax that will be owed on the gains of the investments in the 30-year scenario. Let us know if you’d like a copy to check our math!
The 15-year loan is very straight-forward. After 15 years your home will be paid for. Over those 15 years, you will have paid the bank $66,288 in interest. The 30-year loan would have paid $114,903 dollars of interest and still owe $132,563 over those same 15 years.
The 30-year loan is going to take the $466 of savings by not choosing the 15-year loan and investing with a 6% rate of return. Each month the tax savings (from deducting a larger monthly interest payment) is also saved. In the first month this is only $21 but in the last month before the 15-year loan is paid for this is $123 (if you’d like to see this detail, the excel document is available upon request).
There will be 15% capital gains tax owed on the gains in the investment account, however we’ll assume the investments are not sold to rebalance and no tax is paid until a comparison is made. This is not only for simplicity, but also to make every decision around the investments be as favorable as possible to the 30-year and invest option (you’ll see why in just a moment).
Since, you are paying 0.5% more in interest while earning 6% on a fairly small investment (initially), it takes quite a while to breakeven in terms on net worth.
In net worth terms, the breakeven point is 8.5 years in our example. Up until then, you had a higher net worth by choosing the 15-year mortgage.
After 15 years, when the 15-year mortgage is paid off, the 30-year loan and invest option had a higher net worth by just $10,158.
This $10,158 is after every possible assumption was made in favor of the 30-year and invest scenario and all sorts of investment risks that could have derailed this strategy were essentially ignored.
Whether or not to take the risk to try to have a higher net worth after 15 year will be a personal decision. This decision shouldn’t be made on its own as it will have ramifications on your cash flow and therefore other financial planning considerations. Check out this post that will take this example and look at it in a financial planning context.
1This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. No strategy assures success or protects against loss.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.