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.
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%.