After writing that follow-up Q&A post, I received a question on Twitter from @PathtoFI, and that question, too, merits some attention. But since the discussion didn’t happen here on FinanciaLibre, I’m betting most people didn’t see it – and, anyway, my Twitter response (all 140 characters) was woefully inadequate. So let’s go through this additional Q&A here in a more or less complete way. Because, when we dig in a little, we get some pretty interesting results that probably apply to lots of prospective homebuyers.
The question (paraphrased) was: If a homebuyer plans to pay off the mortgage in 15 years, would a 30-year mortgage still be preferred, or would a 15-year mortgage be better?
My (paraphrased) Twitter reply was: If you’re hellbent on paying in 15 years, go with the 15-year mortgage.
For Shame, Libre!
My answer was inadequate on a variety of levels and didn’t afford the question the sort of analysis it deserves.
To begin with, I made a bunch of unstated assumptions that weren’t necessarily the same assumptions made by @PathtoFI.
I also, because of this, probably appeared to directly contradict the findings of our earlier comparison of mortgage products. Those findings show that, after 15 years, a mortgagee with the 30Y is around 10% wealthier than a mortgagee with the 15Y (i.e., $646k with the 30Y versus $587k with the 15Y).
This 10% wealth advantage is from our “base case” analysis, where pre-tax returns from equities investments made from the excess monthly cash available to the 30Y mortgagee are estimated at 8.4%.
When we conducted our sensitivity analysis with respect to that returns assumption and dropped the equities return rate by 25% to 6.3%, we still concluded the 30Y mortgagee would be wealthier than the 15Y mortgagee – by about 3.5% (i.e., $607k with the 30Y versus $587k with the 15Y).
So our results are unambiguously clear: A homebuyer purchasing a primary residence and planning to pay the mortgage off after 15 years is better off with a 30-year mortgage than a 15-year mortgage…
And here’s where my assumptions about @PathtoFI’s question came into play. Which is, in part, why I answered the question the way I did.
Chiefly, I assumed @PathtoFI was asking whether it’s better to take a 15-year mortgage or a 30-year mortgage, given the assumption that both would be paid off in equal monthly installments.
In other words, in replying to @PathtoFI on Twitter, I implicitly assumed that the 30Y mortgagee would pay down the debt over 15 years in equal month-by-month payments, just like the 15Y mortgagee would – but would simply have borrowed at a slightly higher interest rate. Which is, naturally, a bad idea.
But @PathtoFI could just as easily have assumed something altogether different. @PathtoFI might have assumed the 30Y mortgagee would pay the minimum monthly amount, invest the remainder in equities and then, at the end of the 15th year, pay the remaining mortgage debt in a final balloon payment. This assumption is much more in the spirit of the original FL mortgage analysis, and so it’s probably what @PathtoFI had in mind.
And the differences between those assumptions make a world of difference.
So, let’s lay it out nice and clean-ish.
IF it is assumed that a mortgagee will pay off the mortgage in 15 years, and IF it is further assumed that the mortgagee will pay off the mortgage over that horizon in equal monthly installments, THEN the mortgagee will be better off with the 15-year mortgage than the 30-year mortgage.
This is because the 15-year mortgage carries a lower interest rate, thus lowering the total interest owed over the 15-year horizon and thus reducing the overall cost burden of the loan. And the 30Y mortgagee under this scenario wouldn’t be taking advantage of the leveraging benefit of the lower required monthly payments. So the overall wealth result would favor the 15-year mortgage product.
IF it is assumed that a mortgagee will pay off the mortgage in 15 years, and IF it is further assumed that a 30-year mortgagee will pay the minimum monthly payments on the mortgage while investing the remainder in equities and then pay off the remaining loan at the end of the 15th year with a single balloon payment, THEN the mortgagee will be better off with the 30-year mortgage than the 15-year mortgage.
This is because the 30-year mortgagee will be using the leveraging benefit of the loan to invest in equities, which, under most plausible scenarios, would provide a sufficiently great return to more than offset the longer loan’s higher interest rate.
But what if it’s also assumed that, in order to pay off the 30-year mortgage at the end of the 15th year, the mortgagee must sell equities purchased over the 15 years with the 30Y’s excess available cash?
Now we’ve got to consider long-term capital gains taxes. To maintain the assumptions made about the applicable tax brackets for our hypothetical buyers described in the original FL post on mortgage selection, we’ll stipulate to a 15% long-term capital gains tax.
After the 15th year, the 30Y mortgagee from our analysis will owe just over $200k on the initial loan amount of $320k. That mortgagee will have $260k of equities value.
So, our hypothetical 30Y mortgagee will require $200k post-tax from the equities account to pay off the mortgage. Accounting for taxes, we calculate the required liquidation amount by dividing $200k by 85%, which gives us about $235k.
Which, after all’s said and done, will leave the 30Y mortgagee with the lovely house and about $25k left in equities.
Our 15Y hypothetical buyer would be left with the lovely house and no k’s in equities.
So, here again we’re left with the 30Y being superior to the 15Y – by about $25k.
If the lower-equities-returns scenario is assumed, then the 15Y is slightly superior.
Running through this quickly: Assuming pre-tax equities returns of 6.3% rather than 8.4% means that, after 15 years, the 30Y mortgagee will have only $221k of equities value. Which means, in order to pay off the remaining loan balance at the end of the 15th year, the 30Y mortgagee will have to access funds other than those just in the equities account. Specifically, a little over $12k will be needed.
So, with this assumption, the 15Y is superior to the 30Y – by about $12k.
If it’s assumed that, after 15 years, the mortgage will be paid off because the house will be sold, then the mortgage loan repayment can come from proceeds from the house sale. In which case the 30Y mortgage is unambiguously better than the 15Y.
When it’s really all said and done, the 30Y still usually remains the superior mortgage option when considering a 15-year planning horizon. But that statement coves with more provisos than a celebrity prenuptial agreement.
“Jeez, FL, analyzing mortgage options sucks as bad as eating glass,” you say.
But my Twitter reply to @PathtoFI was seriously deficient. And my feeling is lots of people have similar questions about this whole mortgage morass and might benefit from this sort of discussion.
So I hope this helps!
Many thanks to @PathtoFI for a great question. I hope your great question at last has an adequate response.
I kind of have to question the question for a minute before I go.
Why impose the pay-in-15-years restriction in the first place? This is the other reason I answered @PathtoFI’s Twitter question the way I did. There’s no real financial argument favoring paying off a mortgage any faster than necessary. Your funds can work much more productively in other investments, and so it’s pretty much a certainty that taking a 30-year mortgage and paying it off as slowly as possible is most homebuyers’ best bet.
Imposing the must-pay-in-15 proposition is kind of like saying: Assuming I’m only gonna work out for 12 minutes a month, should I jog or lift weights? To which I think it’s fair to say: If you’re hellbent on only working out for 12 minutes a month, just stick with channel surfing.
Luchadores, do y’all have any more great questions about the mortgage thing? Please say no. But if you do, write ‘em down in the comments section below and I’ll do my best to answer (if I can)!
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