Personal Home Loan, Home Mortgage

15, 30, or 40 Years? — My Money Blog

After I made the decision to get a fixed rate mortgage over one with an adjustable rate, the next was to decide what length to get. I thought this would be an easy decision, but there are a surprisingly large number of variables to consider!

Viewpoint #1: Get The Shortest Mortgage You Can Afford
With a longer term, you build equity more slowly but have more affordable payments. With a shorter term, face higher monthly payments but you own the home faster and pay less interest. So the traditional advice seems to be: get the shortest mortgage that you can afford.

This is can be a slippery slope, though. 15-year too expensive? Let’s try 30-year. No? How about 40-year? Hmm… barely. Well, maybe that ARM isn’t that bad after all… Affordability shouldn’t be the only consideration.

Viewpoint #2: Get The Longest Mortgage You Can Afford
In my previous post 10 Reasons You Should Never Pay Off Your Mortgage, I explored the reasons why certain financial advisors tell people to get the longest mortgage they can get. Basically, your mortgage is a cheap, long-term loan. If you re-invest this money into stocks, which over the long run are expected to return much more than 5-6% annually, why would you want a shorter loan? It’s a great arbitrage opportunity.

If you believe in this theory, then your answer is simple: get the longest mortgage you can afford, as long as the effective interest rate is lower than what you confidently can earn elsewhere.

Viewpoint #3: Longer Mortgages As Paying For Flexibility
Here’s the thing. Just because you have a 30-year mortgage doesn’t mean you have to take 30 years to pay it off. As long as you don’t have a prepayment penalty, you can simply send in additional money towards your loan principal and pay it off in 8, 15, or 23.5 years. However, if you have a 15-year mortgage, you have to make those higher payments every month or risk losing your home. So going for the longer term essentially sets you a “minimum payment”, which you can exceed as you wish. This can make a big difference if I run into extended unemployment or other large financial setbacks.

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Example: 15-Year vs. 30-Year + Extra Principal
Of course, as you get a longer term, your interest rate will also go up a bit. But if you run the numbers, it actually doesn’t make that much difference! Let’s say that the 15-year is at 5.125% right now, but the 30-year is at 5.625%. The 15-year payment is $2,392, while the 30-year payment is $1,727 – a difference of $665.

However, if I just paid the $665 extra toward the 30-year mortgage each month, I still end up paying that 30-year loan off in less than 16 years! In exchange for the safety and flexibility of lower minimum payments, I stretched my 15-year loan out for an extra year. I view this extra interest as insurance.

Our Situation and Final Decision
In the case of Viewpoint #1, we can currently afford the payment for a 15-year mortgage. On the other hand, subscribing to Viewpoint #2 this would leave us wanting a 40-year mortgage at a relatively low 6% rate. However, while I see the merits of the arbitrage argument, I don’t necessarily think it’s an apples-to-apples comparison when you have two things with different risk/return characteristics.

I ended going with the 30-year fixed mortgage, primarily due to the reasons explained in Viewpoint #3. I am not against paying off our house early – I actually like the idea of having my home paid off as it would help simplify our income planning in retirement. (I could also treat paying it off early as owning a bond.) However, the flexibility of being able to make the lower payments as needed was a big draw, especially given the relatively small premium for doing so. Finally, if we rent the house out one day, the lower payment would also help with managing rental cashflow.

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So why not a 40-year mortgage here as well? As you go longer, the mortgage payment stops dropping very much. A 40-year loan would involve an even higher rate and only lower our payment by 4%.