If you're about to buy a home or refinance a mortgage, you may be pondering whether to take a 15-year mortgage or one that runs 30 years at a slightly higher rate. The raw numbers back the shorter option. But figures can be deceptive.
If you borrow $100,000 for 15 years at the available rate of 8.5%, you'll end up paying about $177,000 in principal and interest. Borrow for 30 years at 8.9%, and you'll pay out $287,000. Simple arithmetic says you save $110,000 if you can afford a 15-year loan's monthly payment of about $985, vs. $797 on a 30-year deal. The $188 a month extra adds up to $33,840 over the 15-year term of the loan.
REAL COST. But the real extra cost is considerably higher, claims San Francisco financial consultant Tim Kochis. Each year that a mortgage amortizes, a smaller portion of your monthly payment goes to pay interest--which is tax-deductible--and a larger part repays principal. As you lose the deductions, you have to earn more pretax dollars to make the monthly payment. Assuming you are in the 30% tax bracket, you need $1.43 pretax to pay each nondeductible $1.
So, look again. After accounting for lost interest deductions, Kochis calculates, you would need $220,253 in pretax income to pay off the 15-year loan. But with more dollars going to interest, you would need to earn just $152,450 to make 15 years of payments ($143,460) on the 30-year loan. The difference--$67,803--is the increased real cost of paying an extra $33,840 on the 15-year loan.
True, you still owe $79,000 on the 30-year mortgage after 15 years. But the lower payment lets you save $188 a month, which Kochis suggests putting into stocks. If the portfolio returns 10% aftertax over 15 years--not unrealistic based on Dow Jones industrial average figures--it would grow to $98,900. That can pay off the mortgage with a decent chunk left.
Richard Peach, deputy chief economist for the Mortgage Bankers Assn., says this makes sense as long as two things happen: The borrower has enough discipline to invest the monthly savings, and the optimistic rate-of-return on the stock portfolio proves accurate.
Another strategy is to continue the 30-year mortgage after 15 years and use proceeds from the growing portfolio to make the payments. The bottom line is that a 30-year mortgage gives you more flexibility--an asset in itself.