This post came to be as a response to the recent discussion on Get Rich Slowly of benefits of either 15 or 30 years mortgage. Obviously, the prevailing wisdom is not to have mortgage at all, and if one is required pay it off as quickly as possible making a strong case for a shorter mortgage.
First of all, do you really need a mortgage? Before jumping into a house purchase one should seriously weigh all factors of rent vs. buy decision, but that’s a perfect topic for another time.
Before we get to the topic at hand, it is important to articulate two important concepts that are intertwined within a mortgage – they are long and short term liabilities. The definition of short and long is usually pretty arbitrary, so here, we’ll choose a threshold of three years. In other words, any payments you’d need to make in the next three years is a short term liability; and any payments from there on – is a long term liability.
Keeping that in mind, the decision about mortgage’s length is more of a balance shift between long and short term, or so it may appear at first. Let’s say, your intent is to pay off the mortgage as soon as possible, and you are not planning of sitting out the entire 30 or even 15 year term. Great! This means that your decision will have no bearing on the long term side of the equation – at the end of the day, your long term liability will always be the principal (house purchase price less downpayment) plus whatever the interest has accumulated. On the short term side, things change quite dramatically. Let’s take a look at the following example:
On a $500,000 house with a 5% mortgage and monthly repayment plan a 15 year mortgage will translate into $3,954 payment, whereas a 30 year only $2,684. What that means is that every month you will need to come up with $1,270 or 32% less under 30 year plan.
And that is exactly what I mean by short term liabilities. Having this extra $1,200 every month will provide a significant cushion for your financial situation. If we were to expand the discussion, I would recommend an all-interest mortgage altogether. Even though, the days of zero-depreciation mortgages are mostly over, under that scenario you’d be looking at $2,083 required payment, further improving your financial situation.
Before you proclaim me crazy, let me address some of the more obvious and likely concerns:
- Why in the world, would you need a half-million house? Great point, you should only buy as much of a house you need and can afford. Half a million in this case is just an example.
- Sometimes interest rates vary based on the term. True – get the rate/term combination that results in the lowest required payment
- More frequent than monthly payments allow you to pay off your mortgage faster. Not true! You are just making the same payment in smaller steps.
- If my payment is lower, I can afford a bigger house. Technically true, but this post is about trying to save you money not inflate your lifestyle.
- I don’t plan on sitting the mortgage out for 30 years. Then don’t – very few mortgages see their full term, most of them are closed due to sale or refinance, so few folks ever sit them out
- Finally, what do I do with all this extra cash, should I spend it? Unfortunately, this is the trickiest part of all…
…You definitely should not be spending this money! Instead you should place it in one of the safer long term investments available to you. If you are planning to pay off the mortgage in 10 or 15 years – check out some government bonds, either directly or by means of a mutual fund. Stay away from equity or corporate bonds, this money is earmarked to ensure your security, do not gamble with it. Bank CDs or GICs are another viable alternative. Keep putting this money away until you are ready to move, refinance, renew, or have enough money to get out altogether. Every once in a while, when you are feeling particularly brave, you can throw in an additional payment or two.
Some things to be aware of under this plan is the bank penalties. Banks may not like early pre-payment, so you’d need to figure out the best balance between penalties and benefits of early debt-free living.
Hope this was helpful. In terms of disclosure, this is a method that we have personally used, so I welcome any kind of questions or comments. I would leave you with one final thought: when choosing among financial products, always ask yourself a question, who benefits from either choice most. Funny enough, banks win with shorter term mortgages and hate pre-payments. Short term mortgages provide them with less credit exposure, faster equity appreciation (in case they’d need to repossess the property), and less interest rate risk (they are less likely to be stuck with too low a rate for a long time).
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