By Christian Messemer, The Stewardship Shepherd

 

Across the street from my children’s school, David Weekley and Beazer Homes broke ground on a new addition to our development. Over the next three years, thirty-plus new dwellings will spring up begging for purchase. It is an in-demand community, with a great location and top-rated schools. Provided the local economy's strength continues, the community sales representative is sure to have an ideal income for the next few years. 

 

Once the model home opens and buyers begin locking down lots, home type, and amenities, there will be a twelve-month lag from breaking ground to closing day. During this period, most buyers will pursue a mortgage. As they begin to examine their financing options, each must answer the vital question, “For how long will I finance my purchase?” The most common response is thirty years, but there is a price to be paid in taking this route.

 

In what follows, I will discuss the benefits of the fifteen-year mortgage: an earlier pay-off date, lower interest cost, and purchase price constraints. Next, I will demonstrate how similar benefits are achievable by selecting a thirty-year mortgage and paying an additional amount each month. Finally, since it is possible to achieve a similar result without locking oneself into a higher monthly payment, I suggest that despite the added cost, the thirty-year mortgage is preferable for one main reason, financial flexibility. 

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The Fifteen Year Mortgage

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By choosing a fifteen-year mortgage, borrowers agree to repay their loan over fifteen years (180 months). There are three financial reasons to pursue a shorter repayment schedule: an earlier pay-off date, lower interest cost, and purchase price constraints.

 

Earlier Pay-Off Date

 

The timing of when you own your home is the most obvious benefit: a full fifteen-years earlier than the standard thirty-year option. Why does time matter? For most people, a home is the most expensive purchase they will make in their lifetime. Once you move in, like clockwork, every month, money leaves your account to repay a portion of what you have borrowed. Most likely, this payment is the largest and most burdensome piece of your monthly budget. Take a moment and imagine what other financial goals and objectives you would be able to fulfill once his payment has ended. 

 

Now think about the timing of when you would own your home. Assume you are newly married and purchased your first home at twenty-seven. By the time you are forty-three and three to five years before your children entered college, you would own your home and those monthly payments would cease. How would that feel? Compare your situation to the owner of a thirty-year mortgage. Buying at twenty-seven and owning at fifty-seven, with retirement a mere ten years away. 

 

Selecting an earlier pay-off date does more than alleviate a budgetary stressor, remove a liability from your balance sheet, and free up cash flow for other uses, it saves you money.

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Interest Costs

 

Tied to the time component is interest cost. Time Value of Money (TVM) principles tell us that the longer one takes to repay a debt, the more one pays in interest costs. Assume you purchased a home for $250,000, put 10% down, and financed the remainder. In the case of a fifteen versus a thirty-year mortgage, the savings is dramatic.

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Chart One: 15-year vs. 30-year Mortgage

 

Look at Chart One above. In this example, choosing the shorter repayment option could save someone over $73,000 in interest versus a thirty-year conventional mortgage. One derives the savings in two ways. First, notice the difference in the interest rates. The fifteen-year has a lower rate. Why? In loaning funds for fifteen years, a lender takes on less risk of default and rewards the borrower appropriately. Based on today’s rates, the difference between the two equals 0.615%.[1]Second, while a lower interest rate accounts for some of the savings seen above, the bulk of the savings comes through the rapid repayment of principal. With a fifteen-year mortgage, the monthly payment will be significantly higher ($1,487.07 vs. $947.40) than the thirty-year. What seems like a drawback is actually an important benefit. Every month, an additional $539.67 is applied to the principal balance. As the principal balance decreases so does the accrued interest costs. When combined, the lower interest rate and the lower accrued interest result in considerable savings.

 

Purchase Price Constraints

 

Finally, the fifteen-year mortgage helps buyers remain financially reasonable in their pursuit of a home. It is not uncommon for prospective homeowners to spend too much on a home, making the monthly payments a challenging endeavor.  Selecting a shorter repayment schedule drastically increases your monthly payment and limits your borrowing capacity. Let me demonstrate. Assume that you have the financial ability to afford a monthly payment amount of $1,500.[2] Should you choose a fifteen-year mortgage, you would be limited by how much you could borrow, while adhering to your spending limit.

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Chart Two: 15-year vs. 30-year Same Monthly Payment

 

While a fifteen-year mortgage limits your financing to $225,000, extending to a thirty-year would allow you to borrow $353,169, or an additional $128,169. These amounts would allow the buyer to purchase two vastly different homes. Should one choose to increase her loan amount to buy a more expensive home and to finance this amount over thirty years, the costs climb quickly

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Chart Three: 15-year vs. 30-year Mortgage Cost Difference with Same Monthly Payment

 

By financing $353,169 instead of $225,000, the borrowers total cost increases to $560,345, or by an additional $267,672. A portion ($128,168.83) of this increased cost is related to the increased borrowing, while the majority of it ($139,503.46) is the interest cost. If you are concerned that your housing wants may cause you to spend more on a home than you should, a fifteen-year mortgage could assist in setting a financial constraint by drastically increasing your monthly mortgage payment, thus decreasing your ability to borrow. 

 

It is hard not to like the fifteen-year mortgage. Benefits such as the earlier pay-off date, lower interest costs, and purchase price constraints all help make this the preferred loan option for the interest-conscious consumer. Before you make the switch, I want to demonstrate that it is possible to structure the payments of a thirty-year mortgage in such a way as to obtain many of the benefits of the fifteen-year mortgage, while also increasing your financial flexibility.

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The Thirty Year Mortgage

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By choosing a thirty-year mortgage, borrowers agree to repay their loan over thirty years (360 months). As we have seen above, borrower may select a more extended repayment period for two main reasons, the lower monthly payment and a higher borrowing capacity. A higher interest rate, higher interest costs, and the potential of borrowing additional funds often offset these potential benefits. Most borrowers understand why a fifteen-year mortgage is the smarter financial option, but opt for the thirty, nonetheless. 

 

Borrowers choose the thirty over the fifteen for two main reasons. Reason one refers to a previously mentioned concept, upping the loan amount. Buyers seek a more expensive home than would be feasible under a fifteen-year repayment schedule. When faced with lowering expectations or raising the loan amount, many opt for the latter. Reason two concerns the monthly payment. As noted above, when compared to a thirty-year mortgage, the monthly payment for the exact same loan amount is much more expensive. This added cost deters borrowers from selecting the more financially beneficial option. 

 

While there is little I can do to persuade a buyer to borrow less, I am able to demonstrate a potential strategy for those that see the value in paying off their mortgage more quickly but are not quite ready to sign up for a fifteen-year mortgage and the increased monthly payment that accompanies it. For these buyers, prepayment is a viable option.

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Prepay the Thirty

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Though you selected a thirty-year schedule, there is no law that forces a borrower to adhere to making three hundred and sixty payments. Not only do you have the option of paying more towards your mortgage every month, but for most mortgages after 2014, there is no prepayment penalty.[1] Every extra dollar you commit pays down your principal balance, shortening your loan and reducing your interest costs. For borrowers who want to pay down their mortgage faster, but do not want to lock themselves into a larger mortgage payment to do it, selecting a thirty-year mortgage and paying extra every month may lead to substantial savings.

 

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Chart Four: 30-Year Mortgage: Various Prepayment Amounts

 

Chart Four above outlines the potential savings our borrower could achieve by adding more to their monthly payment. Look at the savings.

 

• Adding $79/month (the equivalent of paying one additional mortgage payment per year) pays off the mortgage 3.5 years earlier and saves over $15,000 in interest costs.

• Adding $300/month pays off the mortgage 10 years earlier and saves almost $42,000 in interest costs.

• Adding $540/month (the equivalent paying the same as the 15-year mortgage payment referenced above) pays off the mortgage 14 years earlier and saves over $58,293. 

• Finally, adding $605/month pays off the mortgage in 15 years and saves over $61,572.

 

Increasing one’s monthly mortgage payment pays down principal, which reduces a balance more quickly by reducing interest costs. If this is the case, why not just opt for the fifteen-year mortgage and ensure you own your home in fifteen years? Financial flexibility.

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Financial Flexibility

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We live in uncertain times. The experiences of past six months have caused many of us to reevaluate a foundational proposition to any financial undertaking: job security. We take out loans knowing that the income we earn will pay the obligations we owe. A funded savings account that provides a three-month cushion was thought to provide an additional safety net should the job market go awry. That was pre-COVID. 

 

Post-COVID, many of us have come to the realization that our job situation is more fragile than we would like to admit and the amount in our savings account will not suffice. Lay-offs, furloughs, and the reduction of hours in many industries once thought impervious to shocks has many of us looking for more flexibility in our budget, just in case our business or industry faces a similar setback. 

 

For all its benefits the one disadvantage to the fifteen-year mortgage is its lack of flexibility. When compared to the same thirty-year mortgage, the borrower with a fifteen-year mortgage pays $539.67 more per month. This difference appears small when the economy is strong, and the job market is hot. It becomes a point of real concern when you find yourself out of a job and working hard to stay afloat. Now, that extra $539.67 might be the difference between payment or default.

 

The financial flexibility of the thirty-year mortgage plus a prepay gives you over the fifteen-year mortgage is why despite the savings and the guaranteed pay off date, I prefer the thirty over the fifteen. Yet, before I conclude, I would be remiss if I did not mention the cost.

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The Cost

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Any decision carries with it opportunity cost, i.e., the cost of what you give up by choosing a certain option. Choosing the thirty-year mortgage and paying it off in fifteen carries with it an $11,817 added cost, which comes from the difference between the interest rates between the mortgage options. Remember from earlier that a fifteen-year mortgage will receive a lower interest rate since it is a less risky loan? The difference in the rate, is the price you pay for this financial flexibility.

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Chart Five: 15-year vs. 30-year Mortgage (w/15-year Repayment)

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To pay off your thirty-year mortgage in fifteen years, you must pay $1,552.73 per month. The difference between a fifteen-year mortgage at 2.38% and a thirty-year mortgage at 2.99% is $65.66 per month. Over fifteen years (180 months) that equates to $11,817 or 3.8% of your $304,490 total cost. 

 

Choosing a thirty-year mortgage and repaying it in fifteen carries with it a financial cost. Only you can decide if this financial cost is worth the flexibility it offers should you need it, and if another COVID-like shock occurs, if the monthly savings would give you the financial ability to avoid default. 

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Recap

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There are many benefits (an earlier pay-off date, lower interest cost, and purchase price constraints) to the fifteen-year mortgage and one drawback (the higher monthly payment). It is this drawback that gives me pause when examining the benefit of a fifteen-year mortgage, especially when a thirty-year mortgage with prepayments is able to accomplish a similar objective with the added benefit of financial flexibility, for a slightly higher cost. 

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