Choosing a Fixed-Rate Mortgage Term Length: 15, 30, or 40 Years?

After I made the decision to get a fixed rate mortgage over one with an adjustable rate, the next was to decide what length to get. I thought this would be an easy decision, but there are a surprisingly large number of variables to consider!

Viewpoint #1: Get The Shortest Mortgage You Can Afford
With a longer term, you build equity more slowly but have more affordable payments. With a shorter term, face higher monthly payments but you own the home faster and pay less interest. So the traditional advice seems to be: get the shortest mortgage that you can afford.

This is can be a slippery slope, though. 15-year too expensive? Let’s try 30-year. No? How about 40-year? Hmm… barely. Well, maybe that ARM isn’t that bad after all… Affordability shouldn’t be the only consideration.

Viewpoint #2: Get The Longest Mortgage You Can Afford
In my previous post 10 Reasons You Should Never Pay Off Your Mortgage, I explored the reasons why certain financial advisors tell people to get the longest mortgage they can get. Basically, your mortgage is a cheap, long-term loan. If you re-invest this money into stocks, which over the long run are expected to return much more than 5-6% annually, why would you want a shorter loan? It’s a great arbitrage opportunity.

If you believe in this theory, then your answer is simple: get the longest mortgage you can afford, as long as the effective interest rate is lower than what you confidently can earn elsewhere.

Viewpoint #3: Longer Mortgages As Paying For Flexibility
Here’s the thing. Just because you have a 30-year mortgage doesn’t mean you have to take 30 years to pay it off. As long as you don’t have a prepayment penalty, you can simply send in additional money towards your loan principal and pay it off in 8, 15, or 23.5 years. However, if you have a 15-year mortgage, you have to make those higher payments every month or risk losing your home. So going for the longer term essentially sets you a “minimum payment”, which you can exceed as you wish. This can make a big difference if I run into extended unemployment or other large financial setbacks.

Example: 15-Year vs. 30-Year + Extra Principal
Of course, as you get a longer term, your interest rate will also go up a bit. But if you run the numbers, it actually doesn’t make that much difference! Let’s say that the 15-year is at 5.125% right now, but the 30-year is at 5.625%. The 15-year payment is $2,392, while the 30-year payment is $1,727 – a difference of $665.

However, if I just paid the $665 extra toward the 30-year mortgage each month, I still end up paying that 30-year loan off in less than 16 years! In exchange for the safety and flexibility of lower minimum payments, I stretched my 15-year loan out for an extra year. I view this extra interest as insurance.

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Our Situation and Final Decision
In the case of Viewpoint #1, we can currently afford the payment for a 15-year mortgage. On the other hand, subscribing to Viewpoint #2 this would leave us wanting a 40-year mortgage at a relatively low 6% rate. However, while I see the merits of the arbitrage argument, I don’t necessarily think it’s an apples-to-apples comparison when you have two things with different risk/return characteristics.

I ended going with the 30-year fixed mortgage, primarily due to the reasons explained in Viewpoint #3. I am not against paying off our house early – I actually like the idea of having my home paid off as it would help simplify our income planning in retirement. (I could also treat paying it off early as owning a bond.) However, the flexibility of being able to make the lower payments as needed was a big draw, especially given the relatively small premium for doing so. Finally, if we rent the house out one day, the lower payment would also help with managing rental cashflow.

So why not a 40-year mortgage here as well? As you go longer, the mortgage payment stops dropping very much. A 40-year loan would involve an even higher rate and only lower our payment by 4%.

Comments

  1. My how times have changed.
    I remember when I could not get a car loan for longer then 3 years. Now you can get a 7 year car loan to go with your 40 year mortgage.
    Isn’t capitalism grand? It won’t be long until there are 50 and 60 year mortgages and we all can afford $350k houses while making $35k a year.

    saladdin

  2. Independent George says:

    Saladdin – Did you have a specific criticism to make? Obviously, taking out a loan for a period longer than the life of the asset is a bad idea, but that’s really not at issue here, and it’s generally not any more profitable for the creditor than it is for the debtor.

    Reinvesting the difference between the 30 and 15-year loan essentially amounts to capitalizing on the risk of volatility on the stock market. The funny thing is, though, that for the reasons outlined, the 15-year mortgage is inherently more risky than the 30-year. Even if the market tanks for a long period, you’re still in no worse position than if you paid it into the mortgage; the shorter loan basically guards against the risk of a market downturn, while the longer loan guards against changes in income. I’d say the latter is the more important risk, as it’s the one that actually affects your payment obligations.

    I’d rather have savings in cash (or liquid assets like stocks) than as equity in the home; it’s a lot cheaper to convert cash into equity than the other way around.

  3. I think you made a good choice. We went with the fixed 30 year and just send extra payments when we can. It’s nice to have that flexibility.

  4. Ted Valentine says:

    The problem I have with the mentality of getting the largest mortgage possible is that if you believe in the stock market so much, then why would you tie up so much cash flow in a house? That makes no sense. Calling it “arbitrage” is very generous. Why not rent as cheap as possible and pour everything into the market if that is the best choice?

  5. Renting can’t provide the happiness that owning provides!

  6. Renting and investing the difference can make one very happy also.

    saladdin

  7. Did you look at the NYT calculator and try to figure out which would be the most economical? From this it looks like in the 15th year, you save $1,000/year on average for each of those years, relative to a 30 year loan. Not that this would change your ultimate decision.

    http://www.nytimes.com/2007/04.....APHIC.html

    (ps.I think there’s a glitch in the calculator where it doesn’t “work” for the years after the loan is paid off)

  8. Although extending the payoff date by 10 months doesn’t sound that bad, because you intend to make the same monthly payment, the last 10 payments are basically wasted. You are paying $2,392 * 10 = ~$24k for having the flexibility of making a smaller monthly payment, which you don’t intend to use. That’s a high cost insurance policy. $1,500 a year for “monthly payment flexibility insurance.” Is it worth it?

  9. Personally, we’ll be going with a 30-year fixed when we refinance, mostly for the flexibility.

    Using your numbers as basis and the spreadsheet (which I haven’t tested in depth) from “vertex42″ – http://www.vertex42.com/ExcelT.....ments.html – the total amount paid for your 15-year is $430,553 with $130,553 going to interest. The 30-year with extra payments is $453,430 and $153,430, respectively.

    As best I can calculate, investing the $665/month instead needs to yield 7.45% annual return to make up for the interest savings gained by paying the $665 as extra towards principal each month.

  10. If you want the ultimate happiness rent out a home that you own. You won’t be able to do that with a 15 year mortgage, payments will be much higher than your rental income. Of course with a 400k home there’s not much chance you’ll be able to rent it out for the payment anyways. I chose a small starter home for this very reason. Personally a 30 year mortgage worked for my home and will probably work for my next as I plan on moving after 2 or 3 years and renting the place out. Wash, rinse and repeat.

  11. toasty aroma says:

    I think when I can afford a home I’ll be going with the 15 year. I agree with you Finance Buff. $24,000 buys a lot.

  12. Yep. This is the same reasoning i went through 15 years ago. Took the 30 year loan but paid extra like a 15 year loan. Did it for the flexibility to lower the monthly in case of unemployment. I have refinance since then, but almost done with my house payments.

  13. Independent George says:

    Ted – I think that a lot of people who bought in the last 2-3 years are asking themselves that exact question.

    It comes down to the price-rent differential; if the cost of ownership is significantly higher than the cost of renting, then you’re absolutely right – it is far more cost-effective to rent and invest than to own. If the differential is smaller, then it can be better to buy. The wildly divergent price-rent levels of the last few years was probably the biggest indicator that prices were headed for a major fall.

  14. Hey Jonathan;

    I’m happy to see you post up the multiple viewpoints. I honestly think that all of these views have their strong points. Really, it’s more important that you make a decision consistent with your investing philosophy.

    As to Finance Buff’s comment: You are paying $2,392 * 10 = ~$24k for having the flexibility of making a smaller monthly payment, which you don’t intend to use.

    I think that he’s missing one essential factor here: time. Jonathan is paying $24k 2023 dollars for the flexibility. These are very different from 2008 dollars. At a modest 3% inflation, the flexibility cost is equivalent to ~15.5k in current buying power. (and that seems like a low inflation given current government spending)

    From a different view, he’s adding 5% more time to his mortgage for the ability to spend less monthly money. But the actual value of that time is significantly lower b/c today’s dollars are worth more than next year’s dollars.

    There’s definitely a cost there, but it doesn’t seem really exorbitant.

  15. Yes, I like that dial-a-mortgage approach to paying whatever the max you can afford at the time. You have a longer loan, but less stress. I have a 20 year loan now because the interest rate was so low I couldn’t pass it up — but I wouldn’t be against a longer loan either. If we end up renting out our first house when we move to our next house, I may refinance then into a 30 year — getting the payment even a little lower before making it an investment property.

  16. It is quite an expensive “insurance” policy to go for 30 vs. 15 as others have mentioned. The entire reason you have some emergency fund money (or credit) is to cover you if you lose your income source for a temporary period of time. If, as you say, you can afford a 15-year on one salary, the risk that you both will lose your jobs and outlast any emergency money is slim… and if it did happen I am not convinced that being able to reduce your payment by $600 would save your house. Presumably you would have been out of a job for a very long time for that to be an issue. Plus, you have to have the discipline to actually use that extra money and put it towards your mortgage every month, which most people don’t have.

  17. Like anything in life there’s no simple answer. There are just too many moving parts. Some people think the extra interest payments are too much for “insurance” But the problem of measuring that expense is really not that simple. Do we account for just inflation as some have already? Should we also account for opportunity cost? The fact given where interest rates are, many investors will be able to better the mortgage rate. While I think it’s aggressive to use a historic market return, it’s a reasoned argument. Personally I took a 15 year fixed because I preferred saving on the interest and didn’t think I needed the flexibility, but someone else can make equally rational decision and decide on the 30 year…

  18. I always think if you can pay it off and it won’t effect your standard of living too much then go with the shorter term length. No matter what you make now or how well things are going you never know when disaster can strike upon you, your job, your health, etc.. At the end of the day if you like the property own it and know that whatever happens after 15 years it is yours.

    The better question to me is can you afford a 15 year term length. If you can handle the extra payment without much trouble I say go for it.

  19. saladdin – rent vs. buy is another discussion. Nowhere did I say everyone needed a mortgage. I was renting and happy for the last 12 years of my life.

    TFB – The key term is your statement is how sure you are that you wish to make the payment. If you are 100% sure that you can make the 15-year payment (or even more!) then I agree it is not necessary. But if you aren’t sure you can or even want to make the payment, then in my opinion the 30 year offers flexibility at a reasonable price.

    As dong and GatesVP said, this is $24,000 fifteen years from now so inflation will ease the cost a bit. And this is only if I choose to go the full 15 year route and never deviate.

    Really, I haven’t decided how early I want to pay it off. 15 years is so rigid. Why not 20, or 25. At around 6% interest before tax implications, I’m really not in a hurry. I think at these rates “investing the difference” might be a good bet.

    Ted – Good point, but I’m acting here as if you already are getting a mortgage. Buy vs. rent has already been decided previously. Now, what kind of mortgage do you want to pay for it?

  20. I’ve got a question. I was thinking about refinancing my mortgage, and when I was talking to a representative I asked about fees and closing costs. They could tell I wanted to balk at really excessive fees, so to mollify me, they said, “Well you don’t have to pay them up front, we can just roll them into the loan amount.”

    Should this feel oily to me? Because it does feel oily.

  21. That’s like saying “It’s okay to pay excessive fees, we’ll just finance it!”

    So not only do you have to pay the fees, but interest on them as well! Sign me up :P I’d probably look for another broker right then.

  22. Taking the 30 year mortgage for flexablity, then investing the difference and/or paying down the mortgage depending upon how the market and rates looks can still come out ahead of the 15 year fixed.

    Certainly not a good option for everyone, but Jonathan certainly seems to have the finanical strength of will to actually invest the difference.

  23. In terms of broker fees look for one who does a “no-fee” refinance. My wife and I have refinanced 3 times over the past 2 years. Each time it was into a loan with a lower rate (on the down side we start back at 30 years with each refi). The broker we went with paid all the fees…so the transaction was essentially no cost to us.

    I also check this web site occationally (although I have never used them so this is not an endorsement at all): http://www.oneeasyfee.com. They have a no cost option so you can get a quick idea of what the current rates are.

  24. Another consideration is are rates likely to go down further over next few years.

    Also, how likely are you to own the house for more than 5 years? If you buy and then your income goes up a lot, you may want to upgrade and making the higher interest payments in the short term will not have paid off.

    30 year fixed makes a lot of sense to me these days.

  25. Not sure why you needed the extra flexibility with the 30-year considering the fact that you can already afford the house with just 1 salary. The insurance in your case should have been the 2nd salary. I would have gone with the 15-year if the payments are affordable with 1 salary already and used the 2nd salary as the “insurance policy”.

  26. “If you re-invest this money into stocks, which over the long run are expected to return much more than 5-6% annually”

    I hate seeing this assumption – it’s SO vague and takes SO many things for granted.

  27. Nor Cal,
    You did have fees. Nothing is free. It was somehow calculated in your rate. No broker works for free.

    No such thing as No Fee Loans. Does a broker or anyone really work for free, does that really make sense?

    saladdin

  28. When most people opt for the “flexibility” of the lower payment, they’re probably going to end up spending that money elsewhere. In the end, you’re probably not going to always make the extra payments and end up with much less equity and pay more interest. The additional equity and lower interest of the 15 year is difficult to match with your own savings plan when you consider the other volatile factors. You’ll have to find an investment with a rate of return to make up the equity/interest difference, and factor in the taxes you’ll be paying on your investment. That would be subject to the markets. You’ll deduct more mortgage interest with the 30 year, but its not a big savings once you compute the difference over the standard deduction.

    I’m closing on a home soon that’s about 50 miles from my current home, which is still for sale. Both will be a 15 year mortgage (at 4.875% which is awesome!). I can afford to make payments on both homes for a good while since neither payment is more than 20% of my gross monthly income. I saved up the money to put down 20% on the 2nd home. This gave my family the flexibility to buy a home without waiting on our current home to sell. Having kids and pets, temporary living was not an option, and this makes the move easier. Once our current home sells, I can put that equity back in investments.

    The key is living below your means to keep the 15 year payment manageable, and saving extra money to have as an emergency fund. Buy a home much less that you can afford, and save as much as possible. Otherwise, you’ll be tied to a job and location just to keep up your house payments.

  29. Saladin is right. I used to write mortgages and you will pay fees in some manner or other. Some fees are negotiable but, at least here in Texas, the big fees are required and include title insurance (to make sure there are no hidden liens on the property at the time of finance or refinance) and is state mandated. You pay every time there is a new loan, even on a refi that is done right after the initial mortgage.

    The good faith estimate (which is just that, an estimate) you get from the lender should outlines these fees. If it is a “no cost” finance, the fees will typically be reflected in a higher interest rate but you still want the broker/lender to disclose them and show a discount on the GFE for the higher rate.

    Best bet, get a good faith estimate from each broker/lender you are looking to work with and compare fees. Talk with the broker/lender about the fees separately from the interest rate to compare deal to deal on an apples to apples basis, then pick your favorite and try to negotiate some of the fees away. There are a lot of nickel and dime charges like “doc prep” and “attorney’s fees” that should be negotiable.

    Then, when you get to closing, don’t be surprised to find your closing costs do not match the GFE exactly as things can change when they underwrite, homeowners associations typically get a separate title policy that may or may not be covered up front, brokers may change lenders on you to try to get you a “better” deal.

  30. If Jonathan pays $24K more going with a 30 year loan, that is also $24K more he gets to deduct in interest. Assuming a 25% tax bracket… (which is probably low considering were looking at 30 years and tax rates are at historic lows for higher income earners.) That is $6K less he’ll be paying in taxes over that period. That is $18K for the flexibility of a MUCH lower payment.

    Now let’s assume inflation is 2.4% yearly. Over 30 years, using the rule of 72, we see that $18K in 2038 is actually only worth $9K in todays dollars. ($9K invested at 2.4% for 30 years would double.) I realize the math there isn’t exactly right do to the periodic payments, but there is definitely a significant inflation component when you are looking at 30 years…

    No brainer, take the 30 year loan… I can’t believe smart people even consider the 15.

    Put another way, take the worst 30 year period for any index you can think of… I bet you would be hard pressed to find one that did worse than 6% over that time.

    Heck just looking over the 31 “TEN”-year rolling periods since the S&P 500 started, there has been only one ten-year stretch in the history of the S&P 500 where it didn’t average at least 6%… In that 10 year period from ’69 to ’78 it returned around 3%…

    In other words, history is laying 30 to 1 odds that the S&P will give you a better return than if you put that money toward your house. (Imagine what the odds are against a well diversified portfolio!)

    People who want 15 year mortgages might as well go throw their money on the roulette wheel. The odds that 15 year mortgage is a better investment than the market are about the same as hitting double zero.

  31. I didn’t see “points” mentioned – did you pay any? If you are confident you are going to have this loan long-term then points would have made sense – they pay for themselves. If you aren’t planning on having this loan long term then why bother getting a 30 year fixed when you could get 5, 7 or 10 years fixed?

    As you know I’m not a fan of paying off a mortgage early i.e. turning investable money into “Dead money”. I like your approach of taking the 30 year instead of the 15 for flexibility – risk management is important and why convert investable money into dead money at a faster rate then the bank requires? The cost of that money as somone said should be looked at in terms of net present value and you should take into consideration the extra tax writeoffs for the interest.

    Since you took a second loan, if you really plan to turn a lot of money into “Dead money” to pay off the second loan – then the 30 year fixed makes sense. However, if you plan to furnish the house, fix it up, etc, and the second loan doesn’t get paid off and eventually the property goes up in value, you’ll likely want to re-do the 1st and include the 2nd (refi both loans into one) in which case the 30 year fixed may or may not be worth the extra cost over a 5/7/10 year fixed.

    30 year fixed is safe in case interest rates go up – so other than spending a little extra, it definitely gives piece of mind. As others have said, if interest rates really drop much, you’ll be able to refi at no cost or if you ay closing costs again they will pay for themselves with the money you save…

    Good luck and congratulations!

  32. new yorker says:

    Jonnathan.

    First of all great blog. Believe me – your blog has led to some of the life (actually career) changing decisions for me.

    As far as debate b/w 30year and 15 year mortgage is concerned, I’m still having a hard time understanding ur decision of going with 30 years. As per my calculations, you and your wife are making around 11k/month after taxes. A house payment of 2392 is still at 21% of your after tax income. I see your point that you may want your wife to sit at home after you have kids, but by that time your individual pay will increase and you would have had some more savings too. Additionally even in that situation your wife could work part-time – say once a week.

    A 24 K premium for that flexibility does not sound right to me, esp. when your wife is not as finance savvy as you. Heck – you’re the guru for teaching us how to make $100 from credit card signups, and you are considering a 24K premium as OK?? Think about it – how much time did it take for you to save your first 24 k (it took me about 14 months to save mine) – that is what you are giving away for this so called “flexibility”.

  33. I feel like people are focusing on the wrong thing here. You’ll notice I never said I wanted to pay off the loan in 15 years. I can afford to, but I don’t necessarily want to.

    I just ran a comparison, and the result was that you aren’t really giving up that much by going for the 30-year loan. If the 15-year loan was a huge savings, then I would consider perhaps go for it. But why make such a commitment?

    Going back to Viewpoint #2: As long as what I don’t put towards the mortgage payment is invested in something that earns more than about 4.5% annually (6% + tax benefits), any gap will be reduced and I can even come out ahead easily. Will it happen for sure? No, but definitely something I’m comfortable with.

    I’m even thinking of saving up for another property already, if prices do come down further. The $24k number is just one situation out of thousands of possibilities, and I think it’s more likely that the 30-year will turn out to be the best deal for me than not. Flexibility!

    —-

    Paying points is coming up later… The breakeven point is actually a lot sooner than I thought. This also lowers the rate even further, which reduces my inclination to pay the loan off early even more…

  34. It looks like you comparing interest rates for a $300,000 loan. For a 15 year loan at 5.125% you’ll pay the $300,000 in principal and $130,553 in interest at the end of the loan. For the 30 year at 5.625%, you’ll pay $90,348 in principal and $220,506 in interest by the end of the 15th year. That’s a total dollar difference of $299,605 (($300,000-$90,348)+($220,506-$130,553)). Your $665/month would have to earn 10.9% over the 15 years to match the difference. And with the 15 year loan paid off, you could invest the monthly payment for the next 15 years, or pay for you kids college tuition!

  35. Vern, I would recommend checking your math. You are counting some things twice.

    At the end of 15 years, with the 15-year you’ll have $300,000 of principal paid off, while with the 30-year you’d only have $90,349 paid off. So in terms of principal you are ahead by $209,651.

    Interest paid doesn’t matter. Just know that the 30-year had $665 extra each month. If invested in each month, you’d only have to earn around 7% annualized to match that.

    In addition, here I’m ignoring taxes. You might get long-term cap gains on your investment, or you might even use this money to max out your IRA and 401k. Many people will also be able to deduct mortgage interest at their marginal income rate. In reality many people will have to earn less than 7% to even things out.

    Again, this is still comparing both being paid off in 15 years, which is what I consider the worst case scenario. I know the 15-year is cheaper, the 0.5% rate difference guarantees that, but what if you don’t want to pay it off in 15 years? Having to earn 7% to break even is a pretty good worst-case scenario.

  36. That was my point. By going with the 30 year, you will have $209,652 less in principle, and pay $89,953 more in interest, so the total amount you would need make up in your savings would be $299,605.

    Interest paid absolutely matters if you choose not to pay off your loan early. If you chose to invest in a retirement account, you wouldn’t be able to use those funds toward your next home. The interest deduction is not significant when you account for the differential between the standard deduction.

  37. *You don’t get to keep interest* I’m not sure how to explain it better. At the end of 15 years, if the money spent by both parties is the same, all you have to show for it is either principal or other investments/cash held somewhere. Any interest paid is gone.

    Let me try this:
    —-
    Let’s say both Bob and Jane took out a $50 loan. They spent the same amount of money, the same monthly payment each month. Bob paid off his $100 loan. Jane didn’t, and has $50 left on the loan but $50 in the bank. Who’s ahead? Nobody, because if Jane wanted to, she could just spend the $50 in the bank to pay off the loan.
    —-

    Unless you can show me otherwise, I am afraid I still believe your math to be incorrect.

  38. Comparing the two loans, without any extra payments, after 15 years you would pay $130,553 in interest on the 15 year loan and $220,506 on the 30 year loan. That makes the cost (which I agree is not in your pocket) of 30 year loan $89,953 more than the 15 year loan after 15 years. So to offset the additional cost of the 30 year loan, you would have to make that up with your investment. In addition, you’re way behind in principal, so you have to make that up as well.

  39. I payed off my mortgage about two weeks ago. I had a 15 year mortgage at 5%. The reasons that I paid it off are,

    1. No tax benefits, itemized deduction is less than standard deduction.
    2. Base on my 70/30 investment asset allocation, the fixed income portion is 3 times of my mortgage. So, I payed off the mortgage and reduced the investment in bond.

    Was that a good move? I don’t know. But, my wife likes it because that one less bill to pay.

  40. Thanks for explaining the difference between 15-yr + principal vs 30 yr term loans.

    I ended up going with the 30 yr refinance, and hope to pay the extra principal a month once my wife starts working again.

    Very cool.

    Rob

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