For many Americans, the lion’s share of their personal wealth is the equity they build up in their homes. Thus, the 15-year mortgage is one of the most powerful wealth building tools available to boost that wealth. It has the obvious advantage of enabling homeowners to be free of mortgage payments and retire sooner than a 30-year loan would have allowed for.
Yet, according to a 2013 statement on the Freddie Mac website, the company’s chief economist noted that, “Nearly 90 percent of homebuyers chose it (a 30-year mortgage) in the first half of 2013. Only eight percent of homebuyers chose 15-year loans, three percent chose adjustable-rate mortgages ( ARMs), and one percent chose loans with other terms.” (For related reading, see: What to Consider When You Finance a Home.)
Why are homeowners appearing to eschew the benefits of the 15-year mortgage? Why do some financial planners completely ignore the 15-year mortgage when advising their clients? Why is the wisdom of the 15 year mortgage so rarely discussed in the personal finance media? (For more, see: When To Consider Paying Off Your Mortgage .)
A Simple Answer
The simplest and shortest answer to these questions is that the monthly payments are close to 50% higher than those of 30-year loans. In general, that will mean that the home buyer will have to either stretch his budget to afford a home or, more likely, have to settle for a smaller or lesser home in order to keep up with the monthly payments. Finally, if consumers don’t want to hear about the benefits of the 15-year loan, some financial planners would rather not bring the issue to the table for discussion and risk engaging clients or prospects in contentious discussions.
With that said, this financial planner feels quite strongly about the issue, and advises clients accordingly. In fact, at the risk of alienating my own clients, I usually respond to my clients objections by stating to them, unequivocally, that if they can’t afford the 15-year payments, they can’t afford the home! How is that for going out on a limb? Of course, ultimately I may back down from my strident position and give in because I’m not in the business of trashing a family’s “American Dream.”
I only seek to help make that dream a financially-sound reality. Let’s look at a new $250,000 mortgage and compare the payments under a 15-year versus a 30-year schedule. Under the 15-year schedule, at an interest rate of 3.75%, the monthly payment is $1,818.06. Using the 30-year schedule, with a 4.5% rate, the monthly payment is $1,266.71… $551.35 less than the 15-year payment. (For related reading, see: Paying Down Debt Early.)
Crunching the Numbers
Now let’s crunch the numbers to see what would happen under each arrangement after 10 years of payments. After 10 years, the balance still due on a 30-year, $250,000 mortgage will be $200,223.59, but the balance on a 15-year mortgage will only be $99,326.06… a $100,897.53 difference! And how much more was paid in total over the 10 years with the 15-year mortgage? $66,162. This means that the homeowner has approximately $100,000 more in equity for only $66,000 more in payments.
At this point I need to tell you that I am a bit of a quant, inclined to always consider the numerical and financial implications of most ideas. My college degree is in mathematics, my MBA is in finance and I began my career as a pension actuary. Why do I tell you this? Because one might point out to me that if the homeowner opted for the 30-year loan, with its lower monthly payments, and invested his mortgage payment savings on a regular monthly basis over 10 years, he might accumulate much more than $66,000 in the investment account: perhaps a sum closer to $100,000. And to that argument, I respond “nonsense” or “dream on.
Over a long investment advising career, I believe that I have become a keen observer of human behavior when it comes to finances. I have transitioned from a purely quant approach to one that incorporates behavioral finance as well. As such, I can say with confidence that consumers generally do not fare that well with attempts at initiating and sticking to personal, systematic savings and investment plans. Even those who are seriously committed to regular savings plans often get derailed by life’s intervening circumstances or by emotional investing tendencies. (For related reading, see: Behavioral Finance: How Bias Can Hurt Investing.)
In other words, when it comes to investing and strategizing to accumulate wealth, it is always best to follow the ancient aphorism, “Know thyself.” Voluntary savings plans may work if one is a Vulcan or Mr. Spock type individual, but for most mere mortal types, not so much.
An Offer of Certainty
What the 15-year mortgage offers the homeowners is certainty: the certainty that they will build wealth relatively quickly. In this case, after 10 years, the 15-year mortgage holder will have built up $100,000 more in equity in his home than he would have built up after 10 years of payments on a 30-year loan.
This is what I call wealth building with certainty, and what I consider it to be a no-lose proposition for the homeowner.
Disclaimer: the opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. No strategy assures success or protects against loss.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.