By JLP | January 31, 2006
This is a post that I moved over from my old blog.
The quick answer is: it depends. The main factors to consider when deciding which mortgage is best are:
1. The interest rate on the mortgage.
2. The rate of return that can be received on the money that would have gone towards paying off the mortgage early.
3. Personal financial constraints.
For example, let’s say someone has a choice between a $100,000 mortgage with a 30-year fixed rate of 6% or a 15-year mortgage at 5.5%. Let’s also assume that the house appreciates in value at 3% per year. We know from a historical perspective that the stock market (using the S&P 500) has returned on average about 10% per year over the last 30 years. The following steps can be used to calculate which mortage looks better on paper (there are other factors to consider that I will discuss later):
1. The 15-year mortgage would have a monthly payment of $817 while the 30-year mortgage has a monthly payment of $600 for a monthly difference of $217 ($817-$600=$217). This $217 we will assume is saved in a Roth IRA and invested annually in the stock market and getting an average return of 10% per year. We will also assume that $817 per month will be saved after the 15-year mortgage is paid off (also in a Roth IRA and getting a 10% return per year).
2. Calculate the total amounts paid towards principle and interest over the two time periods.
(15 years X 12 payments per year) X $817 payment = $147,075
(30 years X 12 payments per year) X $600 payment = $215,838
The 30-year mortgage results in $68,763 ADDITIONAL interest expense. Most people stop here and proclaim that the 15-year mortgage is the best way to go. However, they are missing one VERY IMPORTANT factor.
3. Calculate the investment earnings on the monthly difference.
$217 monthly savings X 12 = $2,610 savings per year invested annually in a Roth IRA.
$2610 invested per year and getting a 10% rate of return will be worth $472,334 in 30 years. For those interested in the math the formula is [$2610 X (1 + .10)^30].
4. Calculate the investment earnings on the monthly savings ($817) after paying off the 15-year mortgage.
$817 monthly savings X 12 = $9,805 savings per year invested annually in Roth IRAs (this amount of money would require 2 Roth IRA accounts).
$9805 invested per year and getting a 10% rate of return will be worth $342,682 in 15 years. The formula is [$9805 X (1 + .10)^15].
5. Now compare the two scenarios to get the full picture. In 30 years, the home will be worth $242,726 ([$100,000 X (1 + .03)^30].
To find the net worth under each scenario simply add the home’s value and the investment balance:
15-year mortgage: $242,726 home value + $342,682 investment balance = $585,408 net worth.
30-year mortgage: $242,726 home value + $472,334 investment balance = $715,060 net worth.
So, in this example a person gains an additional $129,615 in net worth by going with the 30-year mortgage instead of the 15-year mortgage.
How is this possible? Well, since the mortgage rates are 4 – 4.5% lower than the assumed rate of return on the stock market, going with the 30-year mortgage and investing early allows for 15 years of additional compounding. This is the difference maker. But, this ONLY WORKS if the person is dedicated to investing the difference and not spending it on something else like a car note.
Now, even given all that, are there still reasons to go with a 15-year mortgage? I suppose there is a certain peace-of-mind in knowing that the house is paid for. Also, there is no guarantee that the stock market is going to return 10% per year for the next 30 years.
So, there it is. Each person has to decide what is best for them.
Tags: Mortgage Comparisons