Friday, March 21, 2014

Fifteen Years or Thirty Years (Another Great Debate)

How did we arrive at the 30 year mortgage? During the Great Depression the Federal Housing Administration (FHA) began to change the way mortgages were financed. The Roosevelt administration wanted more people to own their own homes, so they began to stretch out the term of the mortgage from the traditional 5 to 7 years; first to 15 years; then to 30 years. (History of Mortgages Obringer and Roos)

If you think about it, 30 years makes a lot of sense. Assuming a 40 year working life, 30 years gives you some time to save for a down payment and then some time to concentrate on saving for retirement once you are debt free.

There is an alternative to 30 years of debt, the 15 year mortgage. Some authors favor the 15 year mortgage as the savings over the course of a lifetime can be dramatic. Using today’s rates, here is how the numbers break out.

30 Year Fixed Mortgage:

Size of Loan: $200,000
Rate: 4.42%
Monthly Payment: $1,003.89
Total Payments: $361,400.40

15 Year Fixed Mortgage:

Size of Loan: $200,000
Rate: 3.39%
Monthly Payment: $1,418.99
Total Payments: $255,418.20

If you choose the 15 year mortgage, you will save $105,982.20 and you will have an additional 15 years to invest $1,418.99 a month towards your retirement. Assuming a 7% return, $1,418.99 a month for 15 years will give you a final savings balance of $449,769.18.

The clear winner (by almost $500,000!) is the 15 year mortgage.

However, life is not as simple as mathematical examples. Reaching a salary level that can support an extra $400 a month in housing expense might require years. Those would be years spent throwing money down the old rent rat hole, years your landlord would be getting your mortgage deduction. Those would be years when the wife would have to work, perhaps delaying starting your family, perhaps denying her the opportunity to be a stay at home mom.

Because life is not a mathematical example, I am OK with the 30 year mortgage. In everything I write, I am assuming the reader is a responsible adult. Just because you sign a 30 year mortgage, that does not mean you have to pay for 30 years. I paid off my mortgage in a little less than 10 years. Just switching to biweekly payments will save over $28,000 over the 30 year lifetime of your mortgage.

It is reasonable to assume that as your career develops over the course of a lifetime, you will receive promotions and raises. It is also reasonable to assume that the Federal Reserve Bank will continue to lower the value of the dollar. It is likely you will repay your mortgage with dollars that are worth less than the dollars given you by the bank to buy your home.

Given today’s unusually low mortgage rates, it does not appear the banks are all that worried about inflation, but who can say. That is why I do not recommend Adjustable Rate Mortgages (ARM) under any circumstances. If you sign one of these things you are taking all the inflation risk, guaranteeing the bank’s return no matter what happens in the economy. Don’t do it. When the interest rates are low there is a great deal more upside risk than there is opportunity for downside savings.

Remember debt is a curse. The ability to loan money to others is a blessing.

There is no “good” debt.

Always! Pay off your debts as rapidly as possible.

Buying a home with a mortgage rather than renting may be a rational decision that will both give your family a better life and save you money in the long run. Who knows what the future may bring? Home ownership might once again prove to be average family’s largest investment, providing a sizable percentage of retirement savings, but don’t count on it.

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