# A 15-Year Mortgage Costs $409,112 More Than You Think

| |Yeah, $409,112 more.

And a 20-year mortgage is $265,103 more expensive than you thought.

Specifically, a 15-year mortgage ends up costing you around $400k more than a 30-year mortgage, while the 20-year loan is $265k more expensive than the 30.

Since people tend to opt for the shorter loan duration under the impression doing so saves them money, it’s safe to say 15-year and 20-year mortgages are much, much more costly than you might have believed.

Which leads to the conclusion: Given today’s interest rates, taking a 15-year or 20-year mortgage rather than a 30-year mortgage on your home purchase is the financial equivalent of chaining yourself to the tread of an M1 Abrams tank.

Bad things, man.

Those are the takeaways drawn from a nasty bit of spreadsheet work I did to try to nail down the real financial differences among 30-year (30Y), 20-year (20Y) and 15-year (15Y) mortgages.

Here’s why I bothered. Most calculators, articles and other resources that purport to outline the economics of these three popular mortgage types miss some pretty important stuff.

Either they ignore opportunity costs outright, or they don’t tax-effect interest and returns, or they don’t account for home price appreciation, or they get halfway through the analysis and then sort of throw their hands up in surrender at the bazillion inputs and assumptions that go into analyses like this. And then they conclude: Do what feels right. Or something equally unhelpful.

Not at Libre!

I’ll get to the calculations that yielded the above results in a minute. But I’ll first mention the obvious. The specific numbers would be different for each unique mortgage because of those bazillion factors that influence the results.

And, yes, there are more assumptions baked into the numbers than there are foul-tasting bits of rind baked into your aunt’s fruitcake.

So, yes, if you change some of the assumptions and you change some of the inputs and you carry the calculations out a little differently, you’ll get different results.

But most reasonable alternative inputs and computations will still lead you to exactly the same general conclusion: Don’t be fooled or misled by *mamarrachos* telling you they “saved tens (or hundreds) of thousands of dollars by getting a 15-year mortgage instead of a traditional 30.”

They didn’t. They should ask for a Mulligan.

**Curb Appeal**

I recently spewed some econ knowledge your way about **debt repayment**. In that post I mentioned that I’d discuss the mistake people make when they arrive at the conclusion that a 15Y or 20Y mortgage will save them lots of money relative to the 30Y.

In that same post, I characterized 15Y and 20Y products as “suboptimal.” But I really should amend my earlier characterization of 15Y and 20Y mortgages as “suboptimal.” They are not. They are ludicrous.

“Ludicrous(loo’ du krus): so foolish, unreasonable, or out of place as to be amusing; ridiculous.” —New Oxford American Dictionary

They’ve gone to plaid.

They’re a travesty.

They’re so bad for personal finances that it pains me to write this – because I’m sure someone reading their daily Libre will have taken a 15Y or 20Y mortgage on the belief and counsel from others that the product would be better for their wealth.

Those people were deceived.

**Staging**

Here’s the “conventional” logic usually invoked to argue in favor of 15Y and 20Y mortgages:

1) By taking a shorter-term mortgage, you pay down principal much more rapidly. As a corollary, your total interest charges over the course of the loan are much lower.

AND

2) By taking a shorter-term loan, you can obtain a lower interest rate. As a result, every dollar borrowed is a little cheaper than with longer loans.

SO

3) Combined, these factors make it seem like a slam-dunk. Yeah, your monthly payment’s a little higher than with the 30Y product. But man-oh-man those interest savings…*We’s goin’ be rich!*

So far so good. I can more or less agree with the conclusion that 15Y and 20Y mortgages save you lots of interest expense. (In my analysis, the 15Y results in about $130k less in interest expense relative to the 30Y. So that side of the equation is unambiguously right.)

But you can’t stop the analysis there. You’ve got to do *the whole other half of the study* to get the full picture.

It’s **opportunity cost**, Luchadores, and it’s a beast.

By taking a 15Y or 20Y mortgage rather than the 30Y, your monthly payments are higher. For the 15Y product, they’re *way* more than you’d pay with the 30Y. And that makes perfect sense. You’re borrowing the same amount of money either way; you’re just paying it back twice as fast with the 15Y.

The trouble is that the savings in interest charges garnered by taking on the shorter-term loans don’t even come close to compensating you for the opportunity cost associated with those higher/faster payments.

This is especially true when the period of analysis approaches the average amount of time homeowners own a house in the U.S. (Which is close to 15 years, depending on how the data are sliced.)

**Inspection**

How’d I go about my calculations to get those eye-catching numbers I dangled above? Pretty slowly, as it turns out. This was kind of a tedious analysis. So I’ve developed an appreciation for why people get roped into these shorter-term mortgages. Running all the numbers for something like this makes you want to claw out your brains.

I’ve also developed an appreciation for why, when you scour the web for reasoned discussion on this topic, there are lots of competing conclusions – all of which initially seem reasonable – but which are often predicated on only superficial analysis.

You’ve got to dig in to reveal the Truth. You’ve got to use amortization tables, tax-effected payments and rates of return, historical statistics… a whole Titanic-load of data.

And an iceberg-sized helping of assumptions.

And a fancy computer to run all the numbers.

And maybe advanced degrees in quantum physics to get it more or less kinda right.

At the highest level, here’s how I structured the analysis. I asked: What is the overall financial result for a homebuyer who finances a primary residence purchase with a 30Y v. 20Y v. 15Y mortgage?

- I assumed three identical hypothetical homebuyers, each of whom selects an identical and rationally-budgeted home to purchase.
- I then assumed one finances the purchase with the 15Y mortgage, one with the 20Y, and one with the 30Y.
- I finally assumed that each buyer has monthly cash income sufficient to service the monthly payment on the 15Y mortgage (since the 15Y mortgage has the highest monthly payment). In my analysis, the tax-effected monthly payment for the 15Y mortgage is $2,044, meaning each buyer has $2,044 in income each month that isn’t needed for other living expenses and can be directed to a mortgage payment if need be.
- For the 15Y buyer, this last assumption means he spends all his monthly free cash on the mortgage during the first 15 years of the analysis. The 20Y and 30Y buyers, who have lower monthly payments, invest the excess cash available to them each month in U.S. stocks.
- Once the 15Y buyer’s mortgage payments end, he invests the full amount of monthly free income in U.S. stocks. (The same is true for the 20Y buyer.)

Accordingly, over each month and year of the analysis, all three homebuyers have the same amount of cash at their discretion to pay their mortgage and/or invest in stocks. The proportions of funds placed into equities or spent on the mortgage simply differ year by year on the basis of the mortgage payment each is servicing.

With this setup established, I ran the numbers and then took “snapshots” of the financial results for the three homebuyers at 5-year intervals following the home purchase (i.e., at years 5, 10, 15, 20, 25 and 30). At the time of each “snapshot,” I assumed the home would be sold, yielding the homebuyer cash equivalent to the sum of his home equity and gains from the sale.

I then compared the overall financial position of the buyers by summing together their cash from real estate and the value of their portfolio of stocks.

Here’s a table summarizing the results.

And here’s a table that translates those results into direct comparisons among the three buyers’ financial positions.

You can see some of the assumptions listed underneath the meat of the tables.

And so let’s address the analysis’ inputs now. Here’s a high-level overview of the inputs and assumptions:

The home price used is $400k because the average U.S. home sales price in 2016 reached around $380k, and I wanted to start with a nice round number for the analysis. So I rounded up.

The traditional 20% down payment was used to avoid private mortgage insurance issues.

The nominal mortgage rates reflect what’s shown on Bankrate as of August 2016.

The tax-effected mortgage rate reflects the impact of income tax deductions allowed on mortgage interest payments. This tax-effected rate implies a household federal marginal tax bracket of 25%, qualification for income tax deduction itemization, and a state income tax rate of 8%. The 25% marginal bracket is probably right for most buyers of $400,000 homes. A calculator for this conversion is available from Bankrate.

Ok. That’s the first batch of inputs and assumptions. Those more or less give us the lay of the land: How much house we’re dealing with, the three mortgage products we’ll compare, etc.

They’re kind of our “initial statics.”

Now we gotta get dynamic. I also used/assumed the following inputs.

Average annual real home price appreciation is 2.8%. This reflects the observed average annual real residential real estate appreciation in the U.S. over the last 30 years.

At the time of the home’s sale, a 3% commission would be paid and zero capital gains taxes would be owed.

Average annual real returns on equities are 8.4%. This reflects the observed average annual real returns to the S&P 500 over the last 30 years.

Since the equities investment would be made in a taxable account, annual dividend income would be taxed at 15%. Depending on the statistics looked at, up to about 50% of total returns derive from dividends. So I assumed roughly half of returns would be taxed at 15%, leaving a 7% annual effective tax rate on the 8.4% returns. Tax-effected annual real returns are therefore 7.81%.*

I’ll relax the home price appreciation and equities returns assumptions for comparison purposes later because they do matter. But maybe not as much as you’d expect.

For the excess cash available to the 30Y and 20Y mortgage-holders to invest in equities, I used tax-effected excess cash to account for the beneficial tax implications of carrying higher mortgage interest on the 30Y and 20Y mortgages.**

**Comparables**

That’s painful to read. And you’re probably taking issue with a few of the inputs or assumptions by now.

That’s cool.

So let’s monkey with the couple of assumptions that you probably don’t like. First, let’s change the rate of stock returns. The 8.4% makes a lot for sense for a lot of reasons. After all, it’s the observed average over the last 30 years. Since we’re looking forward (up to) 30 years, it’s a pretty great starting point.

But let’s chop it down by ¼ to 6.3%. Here are the results if we do that:

Ok. Now let’s keep the lower equities assumption and increase the rate of real estate appreciation by 50% from 2.8% to 4.2%:

All right. Now let’s keep the real estate return at 4.2% and put equity returns back to 8.4%:

No surprises: the main sensitivity in the results is associated with the rate of stock returns. But the sensitivity isn’t really that “elastic.” Reducing stock returns by 25% really only makes a minor directional impact in the earlier years.

Our results make intuitive sense because the stocks investments are the “opportunity cost” alternative. The bigger the delta between the equity returns and the cost of the mortgage, the better the **leveraging effect**.

But we also see that we need a fairly big delta between the tax-effected interest rate on the mortgage and the tax-effected returns on the stocks investment in order to benefit from the free cash flow using the 30Y mortgage.*** It’s not good enough to simply say, “Hell, FL, this conclusion is obvious because the returns on stocks are so much better than returns on residential housing.”

That’s because there’s a big “distortion” brought on by something we’ll call the **scaling effect**. Since the mortgage rate applies to an initially very large sum, while the stocks investment starts small and needs time to grow, you need a fairly big wedge in rate differential to get good overall incremental returns from this sort of leveraging, and the 30Y accordingly needs around 5 years to “pay” for itself as a result.

**Offer**

- The 30Y mortgage makes (much) better financial sense for most homebuyers than 20Y or 15Y alternatives.

- The 30Y mortgage is most powerful as a lever for wealth accumulation when it’s held for the full term.

- Although 15Y and 20Y mortgages look like superior options for 5-year holding periods, I’d argue that, if there’s a high degree of likelihood the house will be sold in fewer than 7 years, a 7/1 ARM or an interest-only loan is much better than either the 15Y or 20Y. The 15Y and 20Y products aren’t much worse than 30Y for 10-year holding periods; but they’re not really better. In part, you can think of their shortfall relative to the 30Y for a 10-year holding period in terms of “
**option value**.” If you’re not sure whether you’ll keep the house for 10 years plus, the 30Y mortgage makes the option of keeping it longer much cheaper, which makes the 30Y more valuable. (This is particularly true given today’s low interest rates, which are almost sure to be higher 10 years from now, making refinancing later a bad bet.)

- The 15Y and 20Y mortgages probably only make any (tiny) amount of sense for people who are able to perfectly accurately foresee that future equities returns will be far below their historical averages during the period of their mortgage terms. Which is pretty much nobody.

**Negotiations**

You hear this kind of stuff: “I prefer paying down my mortgage faster than needed (as opposed to investing the difference) because that **prepayment is a risk-free return** equal to the saved interest expense (say 3.5%). But with investing there’s **risk associated with the higher prospective gains**.”

My response: Ok, I get that. But here’s the thing. If your investing horizon is 10 years or 15 years or 20 years or 30 years (i.e., the horizons we’re dealing with in mortgages), then the risk of negative or substandard returns from equities is very low. We’ve discussed this concept elsewhere on FinanciaLibre, but the headline is this: If you’re passively invested for a very long period in stocks, you’re likely to get excellent returns that approximate the long-run averages.

Nevertheless, there is a real argument for **timing risk or sequence risk**.

Consider this. Over a 30-year period, equities markets could generate the 8.4% real return rate and still leave your mortgage-levered portfolio’s total return in the dust. Because there’s a possible timing problem. That real return can be comprised of over-the-top returns in the early years of your investing program and crap performance later on.

In that event, equity market returns over the period would be much higher than total returns in your portfolio because of the small scale of your holdings during the good years, and the large scale of holdings during the bad.

There’s no way around this issue with equity investing. But note:

1) this sequence risk applies equally to all volatile investments, so it’s not really peculiar to the mortgage analysis, and you wouldn’t let this concern stop you from making “normal” investments in equities;

2) volatility is really more of an issue when the portfolio is being drawn from rather than contributed to;

3) the problem can more or less be accounted for when we reduce the assumed returns from 8.4% to 6.3% (i.e., you’re not likely to get a worse result than 25% below the long-run average just because of sequence risk over a long horizon, so the 30Y is still most likely beneficial even directly accounting for this issue); and

4) that’s just the downside risk (i.e., it could also just as easily go the other way and work to your great advantage).

Let me explain point 4. There’s also upside “risk” that the sequencing scenario reverses. Poor equity returns could all be concentrated early when your stock holdings are small, and crazy equity returns could all occur later when your nut is big and buoyant and beautiful. You can’t know how it’ll go beforehand. So the smart money sticks with returns’ central tendencies.

You also hear: “I like the **discipline** of a 15Y or 20Y mortgage payment. It **forces me to save**.”

Yeah, well, buck up, cowboy. If you really don’t have the constitution to invest the **free cash** associated with the 30Y mortgage, you should be demoted from cowboy to rodeo clown. And rodeo clowns are rarely, if ever, lionized as great financial geniuses. They’re mainly gored and laughed at. Don’t be gored and laughed at.

But, if you are a clown, there are plenty of ways to make investing automated via regular deductions from accounts, etc. I won’t get into the particulars here. But the programs that take care of that kind of thing are good behavioral economics “choice architecture” in action.

**Closing**

I know this is a long and kinda technical post.

But I feel like the mortgage selection topic is important and relevant for lots of people, and I feel like there aren’t great resources out there that do a complete job of getting into this mortgage mess. So I hope this helps.

Note, though: When I took a mortgage on our house (a 30Y, as it turns out), I didn’t do any of this analysis. I went with intuition. But it was what we’ll call “informed intuition”; I suspected the results of a laborious analysis would, at least directionally, be what we found here.

And so, really, I hope *the way* this post will be helpful is by providing some girding for solid intuition about the big levers involved in a decision like this. Oh, and I guess I hope it’ll also help you streamline the mortgage decision when you buy a home. You know, so you just go with the 30Y and stop worrying about it.

*Luchadores, I’d love to know your thoughts: Good, Bad and Ugly. If you’d like the spreadsheets I used in the analysis, subscribe to the newsletter (on the righthand sidebar, under “Get Libre”) and I’ll send them along so you can manipulate the numbers.*

(*Note: I assumed zero equity trading costs, and I assumed no equities would be sold once purchased. This zero trading cost assumption is not material here because of the large sums invested and because of my use of the midpoint convention for investment returns, which can be interpreted to suggest very few total transactions. Separately, quants will say: “FL, you underestimated taxes due from equities investments by using the *real* return rate of 8.4% and tax-effecting that, when you should have tax-effected the *nominal* return and then deducted CPI to get the real tax-effected return.” True. But I also probably over-estimated the returns due to dividends, which is the only taxable component of returns in this analysis. Doing that overstates the tax impact. Together, the factors probably wash; and there’d be no real impact either way.)

(**Note: The use of tax-effected mortgage rates does not substantially impact the results of this analysis. Although the tax-effecting impact serves to improve the performance of the 30Y relative to 20Y and 15Y mortgages, the ability for a homeowner to claim itemized deductions including the mortgage deduction is not necessary for the 30Y to provide superior financial outcomes. Quantitatively, you can see the scope of the impact on inputs by looking at the “Data Inputs” table and comparing the “Free Cash” and “Tax-Effected Free Cash” rows; using these non-tax-effected payments does not result in any directional differences in the conclusions but simply “tightens” the deltas among the three mortgage types.)

(***Note: One sensitivity not addressed that could impact the analysis is the differential in mortgage rates among 30Y, 20Y and 15Y products. Were the rate differentials different, the results of the analysis would change. A large enough differential could cause 15Y and 20Y products to be better than 30Y. But these rates tend to more or less move in lockstep so the rates’ differences don’t fluctuate that much, and rates of all three products have been pretty steady for a while now. Plus, “today’s” rates are used since they’re what current homebuyers are dealing with.)

Very nice analysis! Top notch! I always have to cringe when every few months they roll out a new article on how some financial planner/guru calculated the “savings” of a 15Y mortgage. No surprise because when financial gurus talk to journalists its like the blind leading the blind. Especially at 1-2 business cycle length horizon you’re much better off with the 30Y and equity investments.

As you correctly state, the gross advantage of the 15Y mortgage comes from the slight interest rate differential that has to be weighted against the superior equity return. So, at least there is a “horse race” where you can check which one comes out ahead at what horizon and everything is parameter-dependent. The one bat-s$!t crazy advice I hear more and more these days is to get a 30Y mortgage but pay it off faster, e.g., make extra payments to pay it off in 15 years. Now, that is certifiably dumb advice.

Right on, ERN! Thanks for the excellent comment. I like your “horse race” analogy – a very helpful visual.

And, yeah, paying off a 30Y faster than necessary is the rough equivalent of strapping on some brass knuckles right before you punch yourself in the mouth.

I think the “opportunity cost” concept just gets left out of the conversation lots of times, and it can be a hard one to explain because it’s “indefinite” whereas the interest payments are directly quantifiable and can be typed in bold ink on the page homebuyers look at when deciding on a mortgage.

Financial gurus are the best. In fact, most gurus are pretty awesome for a good laugh. But the finance swamis are the funniest.

Geez, you’re a maniac. I love this analysis. I have often wondered about the benefits of a 15Y vs. 30Y mortgage. Most of the people I have talk to praise the lower interest rates and the forced savings. I am gonna hop on the opportunity to call someone a rodeo clown the next chance I get. I have a 30 year mortgage, but not for any “good” reason, I just wanted the lowest monthly payment at the time. Glad it seems to be the better choice. Happy accidents!

Awwww…thanks, Ms. TJL! It’s literally been

minutessince I was last called a maniac, and I was beginning to get a little self-conscious. 🙂And you really should take the first chance you get to call someone a rodeo clown. In my experience it goes over pretty well…!

All joking aside, the 30Y does seem like the safest choice for most homebuyers. And so it is a bit of a happy accident that it’s the “default” option.

I’m glad you like the analysis. As always, many thanks for stopping by and many, many thanks for the great comment!

Wow great post, Libre, I love the thoughtful analysis. Nobody ever remembers to analyze the opportunity cost but it’s real!

Similar to you, I went with a 30 year based on informed intuition. I thought your and ERNs comments above were very interesting too. While I don’t plan to pay mine off in 15 years, I have been scheduling one extra monthly payment a year which I plan to do until I drop my PMI. I’m close to getting there but maybe that wasn’t really worth it huh?

Awesome post, I loved it!

Thanks for the great comment – that opportunity cost thing is as real as stuff gets. It’s just hard to see it sometimes.

Actually, I’m not sure whether your extra monthly payment is such a bad idea, because of the PMI. I haven’t specifically quantified that scenario, but my feeling is that getting out from under the PMI obligations is pretty valuable.

Thanks again for the comment, and Swan on!

I still have my student loan at 1% as well as my mortgage at 4%. While there were times I paid a few extra bucks on my mortgage, I finally cut it off completely because it made more sense to invest. Your analysis proves the results, great post!

You got it!

Those are great rates, by the way… some sweet leveraging you got going on over there, Mr. CK!

How would you respond to the argument where someone who is maximizing 401k contributions would consider a 15 year mortgage as diversification? In this case, locking in interest savings now is effectively like putting money in a risk-free CD, which still fights inflation.

Also, I think getting a 15 year mortgage for the primary home may be optimal if one is considering buying investment properties to rent out in the future. I didn’t do any math but that’s my instinct. Would you agree?

Anyway, great article! The attention to detail is much appreciated. I subscribed and definitely look forward to checking out those spreadsheets.

Amazing comments/questions as always, wannabelibre! Thanks for adding so much to these discussions here! And thank you for subscribing. I’ll send out the spreadsheets next week.

Let me try to unpack the questions you laid out. First, I’m not sure whether a homebuyer’s level of 401k contributions has bearing on the issue of which mortgage type is superior for that homebuyer. If two identical homebuyers are both maxing out 401k contributions, and one takes a 30Y mortgage while the other takes a 15Y, the 30Y mortgagee can still invest the excess available cash in taxable equities accounts and dramatically outperform the 15Y mortgagee.

Flipping things around, I think we get the same directional result. In the analysis done here, I assumed equities investing in a taxable account, and I assumed those equities are never sold. But if the equities purchases were done, instead, in a tax-deferred account (i.e., both homebuyers could add funds to 401ks or IRAs), the argument for a 30Y would be even stronger because the equities returns wouldn’t have to be tax-effected and the leveraging benefit would be greater. So, whether the homebuyer has room to make more 401k contributions doesn’t seem to matter.

From a diversification perspective, my thoughts are that, when a long-term horizon is considered like 10 or 15 or 20 or 30 years, an investor simply wants to max out total long-run returns; volatility doesn’t matter that much. And so the investor can look to long-run performance of equities versus other asset classes and determine they offer the best bet for maximum gains. Which means, regardless of whether the homebuyer already is investing in equities via 401k contributions, he is still behooved to take the 30Y to enable more equities investing in a taxable account. (Assuming, that is, the investor’s goal is long-run wealth maximization.) This long-term focus is particularly relevant in considerations relating to 401k/IRA accounts and mortgages because both imply long investing horizons.

As pertains to the ideas of locking in interest savings now and fighting inflation, I think both effects are stronger and more beneficial with the 30Y mortgage than the 15Y. Taking a 30Y mortgage locks in historically low interest rates for twice as long as a 15Y. And the inflation-fighting benefit of purchasing a home is found in the avoidance of rent increases over time. Which benefit is identical for homebuyers regardless of mortgage type.

Now, your last point is a whole different animal. If a homebuyer purchasing his primary residence is planning to buy investment properties to generate rental income in the future, there’s a whole slew of other considerations that apply. Chiefly, for our purposes here, that homebuyer will need to consider his ability to obtain financing for those future property purchases. Although the tests for financing of investment properties can differ from those for primary residences, the buyer’s total debt position would almost certainly be considered (depending on whether the investment property purchases are to be made by a company under the buyer’s control or by the buyer directly). And if the homebuyer needs to reduce principal on his primary residence rapidly to obtain that new financing, then a lower-interest mortgage could be preferable to a 30Y. But if that’s the plan, then I don’t know the 15Y would be the best option. If the homebuyer knows he’ll pay the thing off rapidly, he’d be better to get the very lowest interest rate possible without regard for duration. And a 15Y probably wouldn’t provide a lower rate than a more speculatively-geared ARM type of product. Again, though, this whole multi-property question is a very different animal that introduces lots of gnarly considerations. And, for the record, I’m not a tremendous fan of the tenants and toilets business model, even though I recognize the cash flow and tax arguments in its favor.

I hope this all helps. Thank you again for the great thoughts, wannabelibre!

Thank you for your thoughtful reply!

You got it, wannabelibre!

Thank you for your thoughtful questions and comments here. I look forward to your contributions on future posts!

I don’t have the analytical powers for numbers that you display here, but I have always felt that the opportunity cost of rapid mortgage pay off made no sense. I don’t consider a home an investment. I want to find one that is comfortable and cheap. I want my money to go to the stock market and do all the work while I’m busy deciding the appropriate paint color for an entryway.

Ha! I love the paint color comment – that’s great!

Maybe you don’t

thinkyou’ve got the analytical facility for numbers, but I’d say your intuition proves otherwise. Here’s to you finding a great and comfortable place with lots of money left over for stocks!I’m not sure I agree with the assumptions you make in your analysis. You compare a risk investment in stocks, with a risk less investment in debt. I think you really need to compare the return on a mortgage to the return on a treasury or other risk less debt. A mortgage investment has more in common with the bond portion of your portfolio and in my opinion prepayment or choice of a 15 year should be in line with bond fund allocation after accounting for liquidity. Note some bond like holdings are near or above 30 year and 15 year rates, in those cases I might tend to agree with you.

Hmmm… Well, your points are fair, and I appreciate the comment. But I’m not suggesting that this is some sort of riskless arbitrage situation – which is where your analytical structure would pertain.

The deal here is that someone taking a 30Y mortgage has extra cash to play with over a long-run horizon than a 15Y mortgagee does. With a long-term view, the 30Y mortgagee would be behooved to invest the excess cash in the highest-returning long-run asset class to maximize the leveraging benefit – i.e., equities. Over a long-run horizon like 30 years (or even 10 or 15), the annual return dispersions are unimportant, and so it’s not really necessary to “risk-match” as you suggest.

Moreover, investing more aggressively in a home via a faster pay down of mortgage debt is not riskless. Rather, home values fluctuate and do not appreciate substantially over time. Instead, they putter along a little above inflation (using those same long-run averages as used for stocks). So there are two kinds of risks with paying real estate more aggressively: 1) price fluctuation; and 2) price erosion relative to alternative investments like stocks.

All of which is to say the assumptions about what a 30Y mortgagee would invest in with the excess cash available are only assumptions insofar as I’m assuming a mortgagee would be rational about things.

I think it comes down to your view on your home. I don’t view my personal home as an investment I view it as a living expense. As such the mortgage is just a guaranteed expense to be offset by guaranteed revenue. An investment property I would view differently since then it’s about the power of leverage in which case I agree.

Right on about the investment property perspective. Agreed.

And I agree that a primary home is

kind ofa consumption good. But it’s one with some investment-like features. Compare it with, say, a giant can of tuna. To consume the tuna means it goes adios. To consume the house (unless you’re living in Animal House), means you just occupy it for some duration. The essential value to future prospective users is maintained. So it’s a quasi-consumption good.But that doesn’t really matter for the benefit of leverage. Here’s the thing. A mortgage is a way to lever one’s balance sheet. There’s virtually no other way for an individual to get a loan that’s some multiple of their annual income – particularly at interest rates that are just a couple percentage points above the 30-year treasury. It’s not so important that the mortgage is tied to a house for the beneficial leveraging effect. (The fact that it facilitates buying a house is nice, too.) Instead, the important thing is that, over a 30-year period (or 15 years or 10), the returns attainable on the borrowed sum can easily outpace the cost of the interest on that sum. Hence profit. Hence wealth. Hence awesomeness.

I think your concern relates more to the cash flow side of things. And you’re right on point there. You gotta service the debt, or else you’re gonna have to file bk and/or be evicted. Which probably sucks. So this is why I structured the analysis with the ingoing assumption that a buyer of a home using the 30Y mortgage would be able to service the monthly payments associated with a 15Y mortgage. That means there’s enough cash to go around for servicing the debt and investing in equities. If that cashflow condition isn’t met, then the homebuyer should look for a cheaper house.

Good discussion we got going here. I dig your perspective, and I’ll be interested in your thoughts on other posts. Thanks for the insightful comments!

Good discussion, however what are your thoughts on paying off the mortgage by the time one reaches retirement? In your argument above I assume you are looking at future income (from a job?) to pay off a mortgage vs. investing in equities. For a retiree eliminating the mortgage payment reduces the monthly cash flow needs.

Great question, Frank.

And you’re right. My analysis assumes income accruing monthly (as from a job) that is used to cover mortgage payments and/or invest in equities.

Now, I’m retired and carry a mortgage despite having the ability to pay the mortgage off in full if I so chose. I nonetheless continue to benefit from the leveraging since the (likely) expected long-run returns on my equities holdings and other investments in my portfolio exceed the interest expense associated with the mortgage. I’m borrowing money at a low interest rate and using that money to maintain investments in things that provide a (much) higher rate of return – one that fully exceeds my cost of borrowing on the mortgage.

The tax considerations are somewhat different for most retirees than most working folks, so the leveraging benefit may not be quite as large from that perspective. But, if the question for a retiree is: Should I use funds I hold to pay off my mortgage, or should I use those same funds to maintain high investment levels in wealth-producing assets like stocks? Then, my strategy is to keep high investment levels in things like stocks while continuing to hold the mortgage debt. (Note: In this construct, the timing of the “payoff” of having a mortgage is actually much better than for working folks who don’t have funds equal to the mortgage loan in things like stocks.)

All this discussion so far is treated from a “wealth-maximization” perspective. But cash flow is a very valid issue. If it’s a strain to maintain cash flow in order to cover mortgage payments and other costs of living, then it could make sense to reduce the mortgage payment – but if that is the case, I’d argue the best way to do so would be by obtaining a less costly home.

I hope all this helps. Thanks for the great question!

Well shoot I took out a 20y in 2014 🙁

Ok here is one theory for you to likely poke a million holes in. Similar to the argument of a shorter term mortgage “forcing” you to save, there is an effect of taking out a shorter term loan (at least in my experience of my first and only home) that the larger monthly payments may steer you towards a smaller lower cost home. 30yr rates (along with hgtv of course!) make it very “affordable” to live like a king in a 2500+ Sq ft home. By going with a higher monthly payment and a smaller home you could save quite a bit on furnishing, maintaining and the stress of a bigger home.

Ok that was my best justification I could think up!

Thanks for the great comment, Dan!

You’re 100% right – the higher payments associated with shorter loan terms can serve to keep overall budgeting for the house, furnishings, etc. in check. In fact, in a different FL post relating to this topic, I recommend as a rough guideline for home price budgeting to compute the 15-year mortgage payment for a prospective house. If that payment can be easily tolerated by your budget, then the house might be a good financial fit, and if not then it’s likely too expensive… But then, once that exercise has been undertaken, the mortgage actually taken ought to be the 30-year to maximize the financing/leveraging benefit.

Having said all that, the far more important lever in all this is appropriately budgeting the home purchase price, as you’re implying. If that’s done well, the mortgage selection is very much a secondary consideration. And if the home purchase price isn’t appropriate for someone’s overall budget, no amount of financial engineering with any mortgage will save the day.

So I wouldn’t worry about the details of mortgage selection too much – you pulled the really big lever the right way in budgeting smartly off the bat! And it sounds like you’ve got a great spot to live in. So it’s a win!

Thanks again for the thoughtful comment!

I don’t think this is a logical calculation. First, 8.4% real return for stocks is way high. You say that in a 2% inflation rate the stocks should return 10.4% on the average. This means that a 10% bear market should be followed by a bull market of 22% – 23%. It is just insane. After having good returns for so many years I don’t even think that the return will be positive over the few years. This is because the insane returns we saw were mainly because of extra lower interest rates the Fed has been pushing for 10 years. I don’t think these rates will stay low. On the other hand, inflation will probably surpass 2% and we will see unexpected rate hikes which the Fed will have to do to keep prices stable. Make your calculation again where your mortgage costs 5%-6% and the stocks return about 4%-5% in real terms.

Thanks, Bora. The 8.4% real returns figure is the long-run average for U.S. equities. So, yes, it’s an assumption in the calculations and therefore subject to critique. The calculations done here also reflect sensitivities modeling for below-average returns, though, that are more in line with your suggested return range. Your suggested mortgage cost range is quite steep given current rates and probably not appropriate for most folks. But your points remain: This calculation set encompasses assumptions and given values that are open to criticism. If you’d like to model the changes you suggest, I’d be interested to see what your results look like.

I also invite you to check out the more recent series of posts relating to forecasting future U.S. equities returns scenarios since you seem interested in equities forecasting!

Thanks for your thoughts!