What's wrong with a 15-year fixed rate mortgage? Plenty
Filed under: Borrowing, Real Estate
With mortgage rates hovering around record lows, the mortgage refinancing business is booming. The days of pay-option NINJA (No income, no job/assets) loans are over, and fixed rate mortgages are cool again. The New York Times reports that the ultimate conservative financing method -- the 15-year fixed rate mortgage -- is gaining on the 30-year mortgage.
But is that too conservative? I think so. In fact, I'll go out on a limb and say that with interest rates this low and the specter of inflation as strong as it is, you would have to be nuts to take out anything other than 30-year fixed rate mortgage right now.
Here's why: A 15-year fixed rate mortgage achieves very little savings compared with a 30-year mortgage, but lacks any of the flexibility. Let's look at it with numbers (courtesy of BankRate.com):
- The interest rate on a 30-year fixed rate mortgage is 4.98%. The monthly payment on a $200,000 loan is $1,071.20.
- The interest rate on a 15-year fixed rate mortgage is 4.63%. The monthly payment on a $200,000 loan is $1,543.31.
Of course the advantage to the 15-year loan is that you only have to make the payments for half as long. On the 30-year loan, you'll spend at a total of $385,632 compared with $277,795.80 for the 15-year loan. That "savings of $107,836.20" is what sells most people on the 15-year mortgage.
But when you look at it more closely, it falls apart, and here's why: Most of that savings comes from paying the mortgage off in 15 years instead of 30 (You can pay off a 30-year mortgage in 15 years if you want to), not from the lower interest rate. All other things being equal, paying off a mortgage in 15 years at 4.63% vs. paying it off in 15 years at 4.98% only saves you a whopping $36.19 per month.
But by committing to a 15-year mortgage instead of a 30-year mortgage (with the option of making extra payments), you give up flexibility: What if interest rates rise and you can invest in Treasury Bills that yield 10%? You will have screwed yourself out of a lot of money by plowing that extra $472.11 into your house to avoid paying 4.98% interest on it.
Worse, plowing that extra money into your house is a good way to end up house poor -- tons of home equity but little in the way of other assets -- which can lead to disaster if you need cash at a time when interest rates are high.
Let's say that mortgage rates are at 11% in five years (stranger things have happened following debt-fueled federal spending binges) and you decide that you want to take out a home equity loan to help your kids pay for college. You have a lot of equity built up in the house -- you only have 10 years left on the mortgage -- but you have a problem: Even though the interest rate on your mortgage is 4.63%, borrowing against the value of your home would require you to pay an interest rate of 11%, and you can't afford those payments.
If you'd taken out the 30-year mortgage and saved the extra $500 per month, you'd have plenty of cash to pay for college and wouldn't need to take out a loan. But you didn't so now you have three options: 1.) Find another way to pay for college. 2.) Tell your kid to go to a cheaper college. 3.) Sell the house to unlock the equity, even though you really don't want to.
And all that to save a lousy $36.19 per month -- even though it's actually less than that if you take a tax deduction for the mortgage interest. It just doesn't make any sense at all.
The bottom line is that the 30-year fixed rate mortgage offers you tremendous flexibility and with rates as low as they are right now and long-term inflation likely to ensue, I think you would have to be crazy not to lock in the right to borrow money at 4.98% for as long as you possibly can.
And if I'm wrong and rates head down to 3% (I will bet anything that that doesn't happen!), you can refinance!
Reader Comments (Page 1 of 1)
5-26-2009 @ 8:39AM
Diane Stirling said...
There is a difference. First, if the person is older and doesn't want a mortgage hanging around after they retire, if they can afford the extra $500/month, then it's paid off 15 years earlier (which is about a savings of $180,000 over those last 15 years).
If they want the 30-year, then pay $1600/month, and you'll gain on the principal and still have 'flexibility' to drop back to the lower monthly rate if you have a job loss or down-turn in income.
There are other examples that can be pointed out, but these 2 are the most obvious.
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5-26-2009 @ 3:40PM
Jeff Parker said...
Zac: "All other things being equal, paying off a mortgage in 15 years at 4.63% vs. paying it off in 15 years at 4.98% only saves you a whopping $36.19 per month."
Zac, I'm saving the negligible $36 for the first 15 years. For the next 15 years, it's a different story, right? While you continue with your "flexible" $1,000 payment, I'm free to invest wherever I like. And imagine how better I'm at budgeting since I've grown accustomed to the higher, 'inflexible' mortgage payment.
Wow, it's mind-boggling how well you marketed bad financial common sense. We've had more than enough of that already, haven't we?
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5-26-2009 @ 11:50AM
Qui said...
Well, if you are financially capable and smart enough to choose a 15 year mortgage; you most likely will not 'screw' yourself by not thinking ahead.
Most people that choose a 15 year mortgage are usually going to take into account that jr is starting college in 5 years as well as other known, expected future expenses.
As far as someone choosing a 30 year mortgage over a 15 year mortgage and saving the difference; many people will not have the discipline to save the $472 each month.
The savings between a 15 year and 30 year mortgage is substantial. Rates between the two terms are usually substantial as well. By choosing a 15 year fixed mortgage you can realize a savings of ‘107,836.20’, which is substantial!
Finally look at the first payment of a 30 year mortgage (200,000, rate 4.98)…
Total payment: 1071.20
Principle paid: 241.20
Interest paid: 830.00
Compared to a 15 year fixed (200,000; rate 4.63)…
Total payment: 1543.31
Principle paid: 771.64
Interest paid: 771.67
I wouldn’t want to p*** away my payment of $1071, with less than 25% going to principle.
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5-26-2009 @ 2:21PM
Tim Manni said...
I think Zac's over-arching theme is flexibility. Jeff, congratulations on being financially sound and making the right decision with your 15-year loan, but I don't Zac's advice is "bad."
The bottom line is you can still pay off your mort in 15 years, even if you have a 30-year term. It just all depends on if you really want to, or as Qui put it, "have the discipline" to.
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5-26-2009 @ 3:17PM
Alex said...
Zac: "All other things being equal, paying off a mortgage in 15 years at 4.63% vs. paying it off in 15 years at 4.98% only saves you a whopping $36.19 per month."
This is true... but if you are paying the correct amount to pay your mortgage off in 15 years then you don't have the flexibility of the 30 year mortgage gained from the $500 per month cheaper payment. And that flexibility is the only advantage of the 30 year mortgage.
The savings of $107,836.20 on the 15 year mortgage should really be thought of as saving $300 a month for 30 years. That is starting to sound a lot better.
I agree that if your kids are going to college in 5 years and you know you are going to borrow money for school, then taking the 30 year mortgage and putting money into the college fund is a good move. Otherwise, using your home as a method for speculating on interest rates based on advice from someone who has never spent even 15 years paying a mortgage seems suspicious.
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5-26-2009 @ 5:08PM
Heather said...
I agree with the comments posted here. People who get a 15 year mortgage are aware of the benefits and are most likely not looking to make the changes suggested in the article above. I think that most buyers explore the possibilities and limits of each type of loan before deciding which is best for them. For someone that is retiring in the next 15 yrs, owning his home by then has great rewards. This article seems to talk down to those all of those people who are making intelligent decisions about their financial choices. Surely, people seeking the right mortgage for them will do their own research and come to a decision for what is right for them.
www.hahcreditandloans.com
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5-29-2009 @ 1:38PM
fixed said...
If I am sitting on cash, does it make sense to get 3 year fixed mortgage at around 3 or 4 % and pay it off all in 3 years?
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