A 15-year mortgage can be a great way to accomplish financial planning goals, yet it is often overlooked as it goes against “conventional” investment advice.
The “conventional” advice, especially in the low interest rate environment that we’re in, is to use a 30-year mortgage instead of the 15-year. The reasoning is that the 30-year loan will have a lower monthly payment and the difference between the two payment amounts can be invested for a (hopefully) higher return than the interest rate on your loan, therefore creating more wealth than had you been on the 15-year loan.
For example, let’s say John and Jane are looking at a getting $200,000 mortgage. They can get a 30-year fixed rate loan at 4.5% interest for a payment of $1,013 per month or they can get a 15-year fixed rate loan at 4.0% interest for a payment of $1,479 per month.
The “conventional” approach would suggest investing the difference of $466 per month in hopes of generating a return greater than 4.5% over those 30 years in order to maximize wealth.
We’ve done a full breakdown of this strategy in another post, but often the most eye-opening number is the interest that is paid over the life of the loan. In our scenario, it is $66,288 on the 15-year and $164,813 on the 30-year.
Regardless of the exact breakdown of the numbers, we believe it is better to view the decision in context of one’s complete situation to determine the best course of action.
Financial Planning Considerations
Cash flow is the most important planning that can be done and a mortgage payment is a large portion of one’s monthly cash flow. If both mortgage options are viable considering your other financial goals1, there may be an opportunity to align your cash flow with your future needs with a 15-year loan.
For example, a young family with desires to pay a portion of their children’s education may be able to use a 15-year loan in order to have the loan paid off when their children are entering the college years. This would create some of the cash flow needed to fund their education.
A similar approach for an older couple may be to use a 15-year mortgage to have their home paid off by the time they reach retirement. A paid for home would mean less monthly income needed during retirement.
There is a significant psychological benefit to having your home paid off when entering retirement that doesn’t get mentioned often enough. This may be because the trend is moving towards mortgage debt in retirement being the norm. In 1994, 22% of households age 60-64 had a primary mortgage. In 2017, 44% of households age 60-70 had mortgage debt3.
Regardless of the reason, a home that is paid for means that more of the “essentials” (i.e. food, shelter, clothing, etc.) can be covered by secure income sources such as Social Security and pensions or annuity income. Studies have shown that retirees have greater satisfaction with higher levels of guaranteed income4. We believe much of this satisfaction comes from having the essential expenses met with guaranteed income.
There are other aspects to the mortgage length decision that deserve mentioning that have more to do with personal preference than planning strategies.
Many people have a natural disposition against the use of debt. For most, this does not prevent them from using a mortgage to buy a home, however they are inclined to pay it off as quickly as possible. We think there is a lot of wisdom to this and recommend our clients have little debt.
The 15-year loan can also be “forced savings”. Many people struggle to budget and prefer to not have easy access to what they want to save as they are afraid if they do they will spend it. The higher monthly payment of the 15-year loan can help people like this save. It’ll be in the form of home equity, but it can be an effective tool.
Lastly, some people are risk adverse and paying down the home debt quickly makes sense. For them, the alternative risk-free asset to invest in (with the monthly cash flow difference from choosing a 30-year loan, $466 in our example) is a 90-day Treasury bill. These bills are considered risk free and have paid between 1-2% over the past year. Paying down their mortgage would also be a risk-free investment2 as they will be guaranteed to save the interest rate on each dollar of principal that is paid down (assuming they were on a fixed mortgage). In our example both 4% and 4.5% loans would be better for the risk adverse individual to pay down as the rates are above the Treasury bill interest rate.
An appropriate mortgage will vary for everyone. This can only be determined through careful planning and consideration of the competing objectives we all have. As always, we are happy to assist you determine if your mortgage decision aligns with the purpose at the foundation of your financial plan.
1The affordability of a 15-year loan versus a 30-year loan will depend upon cash flow and many other factors and is outside the scope of this article.
2The risk-free aspect refers to the interest owed on outstanding principal and does not refer to the value of the home nor the equity (home value minus the debt on the home) in the home.
3American Financing, 2017 Retirement and Mortgages Study
4Greenwalk & Associates, 2018 Guaranteed Lifetime Income Study
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.