rdr@inuxh.UUCP (Robert Rindfuss) (03/13/86)
Should you get a 30 year mortgage or a 15 year mortgage? In the past year or so, I've seen and heard so much misleading information about 15 yr vs 30 yr mortgages I'm about sick. It's no wonder everyone is confused. One guy on TV (John J. Givens) is telling you to always take a 15 year, because over the long run the total amount you'll pay is so much less. He even suggests that the banks and S&Ls are perpetrating a scam by "hoping you'll never find out just how much money you'll save if you take the 15 year loan." Then you go talk to your tax accountant and he tells you to take the 30 year loan since the interest you would get to deduct each year with the 15yr loan would decrease more rapidly than with the 30 year loan. I even heard Stuart Varney on CNN's "Your Money" program claim that even if you currently have an old 8% loan, you could be better off refinancing today at 9 1/2% because with a new loan most of the payment would be interest and you could actually wind up with a lower after-tax out-of-the-pocket payment. (What he didn't tell you is that you'll be making those payments for years and years until that new loan is paid off, while if you stayed with the 8% loan you're probably close to being paid off now.) Well, I just bought some investment property and had to make the same decision. I spent quite a while with the computer comparing the alternatives to see who was right, and the results were rather surprising, to me anyway. Hopefully I can dispel some of the myths floating around. First, you really have two questions here: whether to sign a 15 or 30 year loan, then how fast to actually pay it off. Today, nearly all loans issued have no prepayment penalty. This means even if you get a 30yr loan, you are allowed to make the same payments as you would have with the 15yr loan, and if you did you would pay the loan off in 15 years. So answering the first question is easy - go shopping for the best rate and points you can find on both loans; if the two are comparable, get the 30 year. You can always pay it off at the 15yr rate if you decide to, but you're not obligated to. Deciding how fast to pay it off is not so easy. To compare the two, consider a $75,000 loan at 10% interest. The monthly payment for the 30yr loan would be $658.18. Over the life of the loan you would pay $236,944, all but $75,000 of it interest. With a 15yr loan, the payment would be $805.95, total of payments would be $145,071. When you compare the payment totals, it's easy to see why Givens thinks the 15yr is such a better deal - you've saved $91,873 in interest payments over the life of the loan. That's a 39% savings in payment totals for only a 22% increase in the monthly payment. Put another way, you invested an extra $147.77 each month for 180 months ($26,599) and got $91,873 in return. Sounds good? I can make it sound even better. Suppose you just pay $10 a month extra on that 30yr loan. You'll pay it off in 27yrs and 6 mos - a savings of $19,086 for a total investment of $3310 spread over time. Still not impressed? Try this: on the first payment of the 30yr loan pay $100 extra. That's it - a one-time $100 investment. You'll pay off the loan almost 3 months early, saving $1953 dollars. That's almost a 20 times payoff on your $100! These seem like fantastic deals, but are they? If you have a business calculator, calculate the rate of return on that $100 investment that returned $1953 in 357 months. Guess what - it's 10%! Exactly the interest you're paying on your loan. How about the $10 per month that returned $19,086? Again, it's 10%. And what about the $91,873 savings you got by paying an extra $147.77 per month and paying it off in 15 years? Had you instead invested the $147.77 in a bank account at 10% APR (compounded monthly) you would have exactly enough in the account at the end of 15yrs to pay off the loan, and thus you save the same $91,873 (the last 180 payments at 658.18 minus the 147.77 * 180 you invested). What this means is this: if you're deciding between a 15yr payoff, vs a 30 yr payoff and investing the difference, the choice simply depends on whether you can invest the difference at a higher rate than your loan rate. If you can, pay the loan off at the 30 yr rate and invest the difference. If you can't, pay off the loan as fast as you can, because every dollar extra you pay on the loan is a dollar making interest equal to your loan rate, guaranteed, until you pay off the loan, or sell the house. Obviously, even if you can get higher interest rates than your loan rate, but you don't have the discipline to make the investments, take the 15yr loan - it's a safe, relatively high-yield forced savings plan. But how is all this affected by taxes? On the surface, the 30 year loan looks like the way to go. On the $75,000 loan at 10% you would get to deduct a total of $7481 the first year, $72,185 during the first 10 yrs, and $161,945 over the loan life. On the 15 year loan, you deduct $7398 the first year, $59,647 during the first 10 years, and only $70,072 during the life of the loan. If you multiply those numbers by your marginal tax bracket you get your actual tax savings. Do tax considerations make the 30yr loan the obvious way to go? Not really. If you're comparing paying a loan at the 15 yr rate vs paying at the 30yr rate and investing the difference, THE TAXES ACTUALLY HAVE NO EFFECT. The reason is this: suppose you invest the difference between the 15yr payment and the 30yr payment at the same rate as your loan. With the 30 year loan, you will be getting a bigger tax break than with the 15 yr, and the difference will get bigger each year. But remember, with the 30yr loan you're investing the difference, and that investment earns interest and interest (usually) gets taxed. Guess what... the greater tax break you get from the 30yr payoff exactly equals the tax you pay on your investment account. So once again, the decision whether to pay your loan off fast, or pay it slow and invest the difference depends on whether you can get more interest on your investment than you're paying on your loan. THERE ARE SOME IMPORTANT POINTS HERE, THOUGH, THAT SHOULD NOT BE OVERLOOKED. 1. If you opt to pay slow and invest the difference, you will be getting a larger tax break each year than you would with the 15yr. That difference must be faithfully transferred to your investment account each year to replace the interest that Uncle Sam taxed away. 2. Alternatively, put your investment account somewhere that is not taxed, such as a municipal bond. Do this and you get to keep the 30yr loan's bigger tax break. If you can do this, then you will very likely be better off with the 30yr payoff. 3. If you opt to pay the loan off fast, the extra dollars you are investing are effectively earning your loan rate of interest TAX DEFERRED. The interest that's "accumulating" is returned to you in the form of payments you won't have to make in years 15-30. That money will then be ordinary income and will be taxed at that time. You may, however, decide to buy another house and continue to effectively defer the taxes even more. You may wonder how all this is affected if you sell your house before you pay off the loan. Again, whether you pay fast, or pay slow and invest the difference, it'll all depend on the return you can get on your investment. It works like this: if you had taken the 15yr loan, your equity would be greater when you sold than with the 30yr loan. But then, with the 30yr loan you would have money accumulated in an investment account. Guess what - if the earning rate on your investment was the same as your mortgage rate, and you've been faithfully replacing the interest that Uncle Sam taxed from it each year with the 30yr loan's bigger tax break, the account balance plus your 30yr loan equity would exactly equal the loan equity of a 15yr loan. So where does this all leave us? First of all, unless the rate or points on a 15yr loan is much less than a 30yr, take the 30 yr loan. You will then have the flexibility to decide how fast to pay off the loan. Second, if you feel you cannot invest money for a rate of return that's greater than your loan rate, pay off the loan as fast as you can. You'll effectively be earning your loan rate of return on every extra dollar you pay, and the earnings are effectively tax-deferred until you sell the house or pay off the loan. On the other hand, if you have the discipline and savvy to get a better yield on your investments than the loan rate, pay the loan as slow as possible and invest the difference. If these earnings will be taxed, you must replace the lost interest with the extra tax break you get from the longer term loan. It won't matter what tax bracket you're in - if the investment earns your loan rate, the amounts will be equal. If possible, however, put the money where it's earnings won't be taxed, such as a municipal bond. That way you can keep the greater tax savings of the longer term loan. This will be of increasing advantage as the loan progresses, and as your tax bracket increases. If you're going to sell in a few years, there is one more consideration that should be made when the interest rates are low like they are right now. If you think that interest rates will go up, it is very much to your advantage to get a long term (30yr) assumable loan. When you sell, the buyer will assume your loan balance at your low rate, plus take a second mortgage at a much higher rate to make up the balance of the loan. If the combined rates of the two loans (called the blended rate) is still lower than the going rate, the buyer can afford to pay more for your house because he will be making the same monthly payment as if he was getting a new loan at a higher rate but on a lower price house. The key here is keeping the your loan balance high, so his second mortgage will be small, and the resulting blended rate will be low. The longer you pay off a loan the higher the loan balance will be at any time during the loan. Bob Rindfuss AT&T Consumer Products Indianapolis
mark@umcp-cs.UUCP (Mark Weiser) (03/16/86)
In article <403@inuxh.UUCP> rdr@inuxh.UUCP writes: > >Should you get a 30 year mortgage or a 15 year mortgage? Wow, this was an impressive amount of information, all accurate so far as I could tell (I'm no expert). But it left out the one thing most missing from most financial advice: intangible state-of-mind. Some financial advisors claim to take into account the degree of "risk aversion" of their client, but this can still be turned into dollars and cents. What I'm talking about is how *good it feels* to own your own house free and clear after 15 years, even if you waste money getting there. I chose it, and while I attempted to justify it financially to be sure I wasn't taking too much of a bath, it came down to how good it felt. As Herb Simon won the Nobel prize in economics for saying, human beings are not rational calculators of rewards, we "satisfice" instead. -mark -- Spoken: Mark Weiser ARPA: mark@maryland Phone: +1-301-454-7817 CSNet: mark@umcp-cs UUCP: {seismo,allegra}!umcp-cs!mark USPS: Computer Science Dept., University of Maryland, College Park, MD 20742
john@hp-pcd.UUCP (john) (03/17/86)
<<<<<< < < What I'm talking about is how *good it feels* to own your own house < free and clear after 15 years, even if you waste money getting there. < The only way to waste money by opting for a 15 yr over a 30 yr loan is if interest rates rise to greater than your loan. If you had a 30 yr loan and invested what you saved with the lower payments then after 15 yrs this investment would be large enough to pay off your home in full. John Eaton !hplabs!hp-pcd!john
sjc@lambda.UUCP (Sandy J. Cifrodelli) (03/21/86)
I would like to thank all of those who responded to this subject either in the net or in personal mail to me. I really learned a lot from all of you out there. By the way, I refinanced my house and took the 30 YR loan. Sandy