This week’s Money Crunching Mondays post was inspired by some real numbers I was running at home. Between a 15-year mortgage with lower interest rate but higher monthly payments, or a 30-year mortgage with lower monthly payments, allowing for extra savings and investing, which is better?
Should you go with lower monthly payments and invest the rest, or higher monthly payments that payoff the loan sooner?
My initial gut response was to say that a 15-year mortgage is worth it. What’s not to love about 15 fewer years of mortgage payments?
However, the lower monthly payments of a 30-year mortgage allow for investing at higher interest rates. Doesn’t investing at a higher interest rate top paying off debt at a lower interest rate?
When it comes to a 15-year mortgage versus investing, which is better? Let’s run the numbers and find out.
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Contents and Quick Links
- 1 Case study details
- 2 Assumptions
- 3 Comparison of 15 vs 30 year mortgage payments
- 4 Pros and cons of a 15-year and 30-year mortgages
- 5 The benefits of a lower monthly payment
- 6 15 year mortgage vs investing
- 7 Monthly withdraws on investment
- 8 15 year mortgage vs 30 year extra payments
- 9 Investing vs. Extra Payments
- 10 Summary
Case study details
My partner and I want to do a few home upgrades as well as landscaping, all of which will require a home equity line of credit, aka, a HELOC.
There is an existing second mortgage so the new HELOC will combine the second mortgage with the additional funds, resulting in a new second mortgage.
We were given the option of maintaining a 15-year mortgage with even higher monthly payments, or switching to a 30-year mortgage with even lower payments than they were before the new HELOC.
The choice left me wondering, over the life of the loan, which is better?
Original 15-year mortgage
Interest: 5.44% fixed
Since this loan was approved a few years ago, and interest rates have dropped since then, the rate is on the current high side. A refinance would likely drop this to around 3%.
New HELOC to be converted to a 30-year mortgage
Interest: 3.44% variable
Notice that the terms offered for this loan are variable. The interest rate starts out lower than current 30-year fixed rates of around 3.6%. However, after one year, the interest rate increases to 3.74% and remains variable from then on.
For simplicity, I’ll compare $280,000 15-year and 30-year mortgages, and assume a 0.5% difference in interest rate. As I was first researching this post, I ran the numbers assuming a difference of 1%. This was closer to what we were actually quoted for our refinance. However, the average difference seems to be less than this.
With a variable rate mortgage, interest rates will change over the years. This means that they could remain low or go even lower, or, more likely given the current market, they increase significantly.
Since we are currently in a very favorable borrowing market with continually declining interest rates, I’m going to assume that over the next 30 years, they will start climbing back up.
For these estimates, I assume that the loan starts with monthly payments of $1,295. The interest rate remains fixed at 3.44% for 12 months, after that time the interest rate increases by 0.25% every 12 months. If this were to happen, the highest monthly payment would be $2,025.57.
Here’s a comparison of the three different loan terms.
Comparison of 15 vs 30 year mortgage payments
So, is it worth it to pay the higher mortgage or is it better to keep payments low?
Ultimately, this comes down to total interest payments and what you can afford to spend every month on your mortgage.
If we add in the total payments over the life of the loan, our chart now looks like this:
The difference in monthly payments between the 15-year and the 30-year mortgage is $660 per month. You end up saving $118,800 over the first 15 years.
However, you still have 15 years of payments to make.
The overall difference in total payments is $120,700, which is due to the difference in interest rates.
Notice that for the variable rate loan, assuming that interest rates will climb over the next 30 years, you end up spending significantly more money over the life of the loan. Obviously, if rates are stabilized, or even better, decreasing as they have been, then you end up ahead. Variable rate loans can be great if the market is stable and interest rates remain low, or, you plan to sell and buy a different home, with a different mortgage, in the next few years.
The above chart helps outline how much you will spend both monthly and over the years, but does it help answer the question regarding which type of loan is better? Let’s review the pros and cons of each one.
Pros and cons of a 15-year and 30-year mortgages
*90% of people now claim the standard deduction so this is likely a benefit that doesn’t help you
As we can see from the benefit chart, it’s unclear which loan is better, each has pros and cons. The real question then becomes, which pros or cons make the greatest impact on your finances?
The benefits of a lower monthly payment
The major benefit of a 30-year mortgage is the lower monthly payments and therefore added financial flexibility.
If you can’t afford the higher monthly payments, the answer is clear, you go with the 30-year mortgage.
But if you can afford the higher monthly payments, is the 15-year mortgage automatically a better choice? What if you still pick the 30-year mortgage and invest the rest?
15 year mortgage vs investing
If you pick the 30 year mortgage and save the difference, after 15 years you’d have an extra $118,800.
$660 per month x 12 months x 15 years = $118,800
But remember, the 30-year mortgage has a 0.5% higher interest rate, which means $120,700 in additional interest payments.
If you simply save the extra money over the next 15 years, it won’t be enough to cover the added interest payments over the life of the loan.
But what happens when you invest that money?
Let’s assume that every month you save the extra $660 and deposit this into a broad market mutual fund like Vanguard’s VTSAX. VTSAX has an expense ratio of 0.03% and a 7% rate of return since inception.
If you do this consistently for 15 years, you will have a total of $210,400.
And if you continue this even further, over the life of the 30-year mortgage, you will have saved an impressive $810,000.
If we stop at 15 years, when the 15-year mortgage would have been paid off, is the $210,400 enough to cover the remainder of the 30-year mortgage?
Total VTSAX deposits made to investing account: $118,800
Interest earnings: $91,600
After tax (15% cap gains) account total: $196,660 ($118,800 + ($91,600 – 15% tax))
Remaining 30-year mortgage total at 15 years: $180,000
Which means that there is enough to cash out your investment account and pay off your mortgage in full. You’ll even have over $16,000 left over in after-tax income.
This is what happens when you choose a 30-year mortgage and invest the difference. What would happen if you instead applied the extra savings to the mortgage payments in an attempt to pay off the loan sooner?
Monthly withdraws on investment
Interestingly, according to the 4% rule, if you invest the $660/month mortgage savings of the 30 year loan vs. the 15 year loan, you will have a total of $414k in your investment account after 21 years. In theory, you can now safely withdraw 4% of your investment without depleting the principal value and fully cover your mortgage payments. In essence, your monthly withdrawals will cover your monthly mortgage payments.
Of course, it takes over 20 years to reach this point, and will an overall low amount in the account, market ups and downs will have a greater impact on your ability to safely withdraw this amount.
15 year mortgage vs 30 year extra payments
If you applied the extra $660 to your mortgage payment every month, assuming there are no early payoff penalties, you would effectively decrease the life of the loan as well as the total interest paid.
By adding payments you lower your interest payments by $103,000 and pay off the loan in under 16 years.
Investing vs. Extra Payments
Let’s compare each option side by side and determine which method of payoff is best.
- When the 15 year mortgage is paid off you save $2,000/month in an investment account
- When the 30-year mortgage is paid off after 164 months, you again save the $2,000/month in an investment account.
The numbers highlight the importance of either investing or minimizing the interest and fees that go along with borrowing money. In general, the sooner you can pay a loan off, the better.
When does it make sense to go with a longer loan with smaller monthly payments?
When you can’t afford the higher payments.
The very practical and real-life reason to go with a 30-year mortgage is the benefit of financial flexibility. If your monthly income after expenses doesn’t leave room for unexpected expenses and emergencies, you need the lower payments.
However, if you can afford it, paying a mortgage off early will lower the overall interest paid while simultaneously adding equity to your home. This translates to increased net worth.
What you do with the extra monthly income after you pay off a mortgage greatly determines how much you continue to save and build wealth. For example, after a 15 year mortgage is paid off, what do you do with all the extra money?
The extra $2,000 you don’t have to pay every month could mean retirement. Or, it could mean you sell your home and move into your larger dream home. It could mean you can now afford to send your kids to college. All-in-all, it means financial flexibility after 15-years of higher mortgage payments.
The answer ultimately depends on your immediate and future financial goals.
Do you need to decrease your monthly expenses but want to buy a home? A 30-year mortgage is likely your best option, even though it doesn’t help you build wealth in the long run.
Can you afford the higher mortgage but need to save for retirement? Again, a 30-year mortgage is a good option, so long as you are disciplined about investing the rest.
Do you want to buy more real estate? A 15-year mortgage will allow you to quickly build equity and minimize overall interest payments. The equity can be used to purchase rental properties in the form of a HELOC. Continue with 15-year mortgages and you can repeat the process every few years.
Do you just want to retire early or build wealth as quickly as possible and pay the least amount in interest? A 15-year mortgage will be paid off quickly and allow you to aggressively save in an investment account once it is paid off in full.
Which type of mortgage did you choose and would you do it differently after reading this article? Leave a comment and let me know!