Financial Tip #4: Guidelines for the choice between a 15-year and 30-year mortgage

People with substantial liquidity and secure income should choose a 15-year mortgage over a 30-year mortgage.

Tip #4: The selection of a 15-year mortgage reduces lifetime interest payments, leads to a rapid increase in house equity, and reduces the likelihood a person retires with debt. However, many homebuyers cannot qualify for or afford a 15-year loan. 

A Numerical Example

We compare outcomes from a $180,000 15-year and 30-year fixed rate mortgage.  The analysis assumes interest rates of 2.9% for the 15-year loan and 3.4% for the 30-year loan, a typical spread for the two maturities.

  • The monthly interest payments are $1,234 for the 15-year loan and $798 for the 30-year loan.
  • The total interest payments over the life of the loan are $42,193 for the 15-year loan and $107,376 for the 30-year loan.  
  • The total lifetime loan payments are $222,120 for the 15-year loan and $287,280 for the 30-year loan.
  • The remaining mortgage balances after 15 years are $0 for the 15-year loan and $112,435 for the 30-year loan.

Problems with the use of a 15-year mortgage:

  • Many potential home buyers cannot qualify for a 15-year mortgage. Whether an applicant can qualify for a 15-year mortgage depends on—household income, the size of the mortgage and magnitude of other debts.  Lenders restrict monthly mortgage payments to around 30 percent of income and total monthly loan payments to around 40 percent of income.  The applicant for a $180,000 mortgage considered above would require an annual salary of $49,360 for a 15-year loan and $31,920 for a 30-year loan, based solely on the limit on permissible mortgage debt. 
  • A household with a secure job and large levels of liquid assets is better positioned to take out a 15-year mortgage than a household with a less secure position and a lower level of liquid assets.  The choice of a 15-year mortgage necessitates more funds for an emergency; however, financial experts are largely silent about the amount of additional liquidity that is needed for recipients of a shorter-term loan.  One potential rule of thumb is for borrowers to keep liquid funds equal to 12 monthly mortgage payments.  Note as discussed in Finance Tip 3, contributions to Roth IRAs can be withdrawn at any time without penalty or tax, hence, owners of Roth IRAs may require less cash savings for emergencies than owners of traditional retirement plans.
  • The higher monthly payment associated with the use of a 15-year mortgage may cause the household to reduce contributions to retirement plans to meet daily living expenses.   However, retirement plan contributions could increase once the mortgage is paid off.  A decrease in contributions to traditional retirement plans can increase federal and state income taxes.
  • The use of a 15-year mortgage could reduce the amount of interest that is deducted from income against both federal and state income tax.  The potential impact of the choice of a mortgage on taxes is small in the early years of the mortgage when most of the monthly payment is interest and high in the final years when the mortgage payment goes mostly toward payment of principal.
  • Substantial home equity can be seized by creditors even in a bankruptcy situation in most states. People with aggressive creditors or people facing litigation may want to maintain a large mortgage to repel claims by creditors.

Advantages of 15-year mortgages

  • The use of a 15-year mortgage allows for a rapid accumulation of housing equity, which can be used as a down payment for a future house purchase. The higher accumulation of equity from the use of a 15-year mortgage increases the likelihood that a person will be able to pay off the old mortgage and put a large down payment on a new home even if house prices fall in value.
  • Consider the outstanding mortgage balance on a $500,000 mortgage at a 30-year term at 3.4% or a 15-year term at 2.9%.   The outstanding mortgage balances after 7 years are $424,180 for the 30-year term and $293,466 for the 15-year term.  The outstanding mortgage balances after 3 years are $469,697 for the 30-year loan and $415,548 for the 15-year loan.   The use of a 15-year loan can lead to substantial build up in house equity even over short holding periods when housing prices don’t rise.
  • A decrease in resources spent over a lifetime on home purchases increases resources available for other goals.  Monthly mortgage payments are higher during the first 15-years of a 15-year loan but are non-existent after 15 years.  The ability to end mortgage payments after 15 years is extremely important for a person nearing retirement, especially if this person is reliant on a traditional retirement plan, with fully taxed disbursements.  The elimination of all mortgage debt prior to retirement allows retired workers to reduce 401(k) distributions, avoid tax and avoid rapid depletion of their 401(k) plans in years where the market is down. 

Concluding Remarks:

Many real estate brokers favor the use of 30-year mortgages because it allows the buyer to entertain the possibility of a more expensive home.  Many financial advisors favor the use of a 30-year mortgage because it allows the household to make larger contributions to retirement plans and brokerage accounts.  These advisors often overstate the potential tax savings from the use of 30-year mortgages and often fail to discuss the extreme importance of total elimination of the mortgage prior to retirement.

The use of a shorter term mortgage allows a home buyer to accumulate equity quickly. Potential homebuyers should be able to calculate the impact of their mortgage choice on their future mortgage balance and future equity. Go to Excel Hint 4 for a discussion on how to calculate the future outstanding mortgage balance.

The use of a 15-year mortgage requires the homeowner to have a larger liquidity cushion to avoid payment problems from unforeseen events.  Many people with low levels of liquid assets at the time of the house purchase and mortgage origination should refinance to a 15-year mortgage after increasing their annual income and their liquid assets.

Flatting Yield Curves, Mortgage Rates and Choice of Mortgage

Flatting Yield Curves, Mortgage Rates and Choice of Mortgage

Question:  Short and intermediate term government bond rates have risen substantially more than long-term bond rates in recent months.   This pattern of rates is called a flattening yield curve.

To what extent has the government bond yield curve flattened between January 4, 2018 and July 26, 2018?

Has the yield curve for the mortgage market also flattened between January 4, 2018 and July 26, 2018?

Calculate mortgage payments for a 15-year and 30-year Fixed Rate mortgages on these two dates.  Calculate equity after five years for the 15-year and 30-year mortgage rates on the two dates.

Most market analysts at the beginning of the year were advising clients to take out a 15-year mortgage rather than a 30-year mortgage if the client could obtain the necessary down payment.

Have changes in market conditions warranted a change in this advice?

Descriptive Statistics on Government Bondn and Mortgage Market Interest Rates

Below are calculations on government bond yields and mortgage market rates for the two dates.

Government Bond Yields
4-Jan-18 26-Jul-18
2-year U.S. Bond Rate 1.931 2.686
10-year U.S. Bond 2.463 2.975
30-year U.S. Bond 2.786 3.101
10-year minus 2-year 0.532 0.289
30-year minus 10-year 0.323 0.126
Mortgage Market Yields
4-Jan-18 26-Jul-18
5/1 Year ARM 3.45 3.87
15-year FRM 3.38 4.02
30-year FRM 3.95 4.54
15-Year mins 5/1 ARM -0.07 0.15
30-year minus 15-year 0.57 0.52

Observations:

The gap between 10-year and 2-year bond rates and the gap between 30-year and 10-year bond rate narrowed considerably between 1/4/2018 and 7/26/2018.

The spread between the 15-year FRM and the 5/! ARM went for negative to positive from January to the end of July.   This spread remained low.

The spread between the 30-year FRM and the 15-year FRM barely changed.

Below are calculations on mortgage payments and mortgage balance reduction after 5 years for the two mortgages on the two origination dates.

Mortgage Payments:

Mortgage 4-Jan-18 26-Jul-18
pmt 15-year loan $2,127.01 $2,222.07
pmt 30-year loan $1,423.61 $1,527.19
15-year pmt minus 30-year pmt $703.40 $694.88

 

Below are calculations on mortgage balance after 5 years of payments for the 145-year and 30-year FRM on the two origination dates.

Mortgage balance after 5 years of payments

Mortgage 4-Jan-18 26-Jul-18
15-year FRM $216,325.31 $219,268.50
30-year FRM $271,122.83 $273,639.10
Diff. ($54,797.52) ($54,370.60)

Observations:

The gap between monthly payments on 15-year versus 30-year FRM went down between January and late July 2018 despite the slight flattening in mortgage rate yields.  (This occurred because the higher rates had a larger impact on 30-year payments than 15-year payments.)

The mortgage balance reduction obtained by taking the 15-year FRM over the 30-year FRM remains around $53 k.

Conclusion.  The government bond yield curve has flattened quite a bit. The mortgage market yield curve has not changed much.   The 15-year FRM remains the preferred mortgage option for those who can afford higher payments.

 

Interested Readers can go here for some articles on mortgage math and choice.

http://www.dailymathproblem.com/p/top-real-estate-posts.html