A young, financial-savvy Houston couple, Michael and Kay, have made the decision to purchase a home. Amidst their excitement, they need to figure out which mortgage option to select. Should they go with a 15-year or 30-year mortgage? They're conflicted.
For some couples, it can be an emotional decision. They may want the peace of mind of not being encumbered by debt for such a long period of time. For others, they'll approach the decision from a more quantitative standpoint. It's hard to quantify the impact of emotions, but it's possible to look at the choice from a financial perspective.
So, Michael and Kay decide to meet with their financial advisor to discuss considerations of the 15- and 30-year mortgages.
Highlights of the discussion:
- Payments on a 15-year mortgage will be significantly higher than the payments on a 30-year mortgage. It's also a contractual obligation, meaning that a change over time in their ability to pay the higher monthly payments won't allow them to reduce their payments.
- Alternatively, the 30-year mortgage may provide them with more flexibility.
- Although the payment horizon is longer than the 15-year option, the payments are significantly lower.
- They would have the option to pay the home off sooner at their discretion by applying more towards the principal amount of the mortgage.
- Fixed mortgages are one of the few instruments that are not impacted by inflation since payments remain flat throughout the lifetime of the loan. Practically everything else (i.e. income, personal expenses, purchases of tangible items) is positively correlated to inflation. A corollary to that: over time, their mortgage payments will likely be a smaller percentage of their income, and consume less and less of their overall spending.
- If mortgage rates should go lower, Michael and Kay can consider refinancing. If rates go higher, they'll stick with their current mortgage.
For some couples, it can be an emotional decision. Others may approach it from a more quantitative standpoint.
Michael and Kay have decided to purchase a $500,000 home in The Heights. They can make a 20% down payment and will have a mortgage balance of $400,000. It's time to decide between a 15- and 30-year fixed-rate mortgage. They wonder, "Which option would provide the greater potential for wealth accumulation?"
Trying hard to avoid emotion and to enable a fair comparison, they believe the analysis should assume they're investing a fixed amount each month for 30 years. And that amount would be the monthly payment for the 15-year mortgage. Why? Once they've paid off the house, they assume they'd invest that same monthly amount in the market for the following 15 years. This cumulative 30-year planning horizon allows them to compare this 15-year-mortgage-payment-and-15-years-investing scenario with a similar mortgage-payment-and-investing one for the 30-year mortgage.
If they opt for the 30-year mortgage, they'll invest the difference between that higher 15-year mortgage payment and what they actually send to the bank for their 30-year mortgage. That difference will go into their taxable investment account.
At the end of this hypothetical 30-year period, they'll liquidate their investment account, pay capital gains on their profits, and see which alternative generates the greater accumulation of wealth.
Let’s lay out a few important simplifying assumptions:
- Ignore any fees associated with the home purchase (i.e. closing costs). We will also ignore other benefits that may be available to Michael and Kay (i.e. mortgage interest deduction).
- Current average interest rates in Texas for 15- and 30-year mortgages are 2.79% and 3.15%, respectively.
- We'll assume a long-term rate of return on their taxable investment account of 6%/year.
- At the end of 30-years, as mentioned, they'll assume they liquidate their portfolio. Investment gains will be taxed at a long-term capital gains rate of 20%.
Let's look at the numbers:
15-year mortgage option:
Their payments would be $2,722 per month. Once their mortgage is paid off after 15 years, they'll invest that same amount monthly for the next 15 years. At the end of their investment horizon, the total value of their portfolio will be $791,609. After accounting for taxes, their total after-tax accumulation will be $731,279.
30-year mortgage option:
Their payments would be $1,719 per month. They'll invest each month for the next 30 years the difference between that monthly payment and what they would have paid for the 15-year mortgage ($2,722). That's $1,003 each month. At the end of the 30-year investment horizon, their portfolio value would have grown to $1,007,529. After accounting for taxes, their total after-tax accumulation will be $878,239.
The difference in after-tax accumulation between the 15-year and the 30-year option would be $146,956. In other words, if Michael and Kay choose the 30-year option and follow through on investing the difference between the monthly payment for a 15-year mortgage and their 30-year mortgage, their net worth could be higher by that amount. That’s a lot of extra cannolis or fajitas that Michael and Kay could be consuming in retirement.
The difference in after-tax accumulation is a lot of extra cannolis or fajitas they could be consuming in retirement.
From a financial perspective, and using the assumptions here, Michael and Kay would be better off with the 30-year mortgage. In real life, other factors come into play. Will they stay in the same home for 30 years? Will they have the discipline to invest the difference in their taxable investment account? Will they be able to achieve the 6% annual rate of return in that account? Those uncertainties should be acknowledged, and may impact their final decision, but a financial perspective provides one objective basis for thinking through the choice they need to make.
If you’re contemplating such a decision, give us a call and we can help you assess your options. Let's talk!
Disclaimer: The information provided here is general and intended as educational in nature. It is not intended nor should it be considered as tax, accounting, or legal advice. Investec Wealth Strategies and its advisors do not provide tax, accounting, or legal advice. We recommend you seek the counsel of your attorney, accountant or other qualified tax advisor concerning your situation.