The prospect of owning your home outright in 15 years, instead of 30, is an alluring one. And with the kids' college tuition costs or your retirement looming just over the horizon, saving more by paying down your mortgage faster seems like an even better idea. That's why a third of the holders of 30-year mortgages are choosing 15-year loans when they refinance.
But if you are going to use a 15-year mortgage as a savings vehicle, you should ask yourself: Is this really the best use of my money? For most people, the added payments on a 15-year mortgage are not small. On a $300,000 loan at 6.5%, the after-tax outlay in the first year is about $7,500 more than on a 30-year note at 7%, assuming a 40% marginal tax rate. This difference rises to about $10,000 by year 10.
LOCKED IN. The higher monthly outlays of a 15-year mortgage compared with a 30-year can be thought of as an investment. Bigger payments reduce the outstanding loan balance, and hence cut your interest costs. If the 15-year loan requires you to lay out $7,500 more in the first year than the 30-year mortgage, that's money on which you don't have to pay 6.5% mortgage interest. It's as if you took that $7,500 and put it in a savings account earning 6.5% interest. That's certainly an attractive deal in today's markets, where a five-year certificate of deposit yields at the most just 5%.
But there are some real disadvantages to investing your hard-earned money in a shorter-term mortgage. For one, unlike mutual funds or most other investments, you're locked into making payments no matter what happens. "You're reducing your financial flexibility," says Mark Zandi, a housing economist at Regional Financial Associates in West Chester, Pa. "You need to make sure you have a sufficient cushion of savings in case you or your spouse becomes unemployed."
Moreover, a guaranteed 6.5% return may seem inadequate in a few years. If interest rates rise, you may wish you had more money available to invest in a high-paying CD or money-market fund.
DIVERSIFY. If you want to boost your savings rate, one alternative is to take out a 30-year mortgage instead of a 15-year loan and invest the difference in payments in mutual funds or other financial assets. This strategy, while riskier, may have a higher payoff: The historic return on stocks, for example, is about 10%. And this sort of diversification makes a lot of sense if you have most of your assets in real estate, as many people do.
After all that, if the 6.5% return on paying off your debt faster still looks attractive, you can send in bigger-than-necessary payments on your 30-year mortgage. That has much the same results as taking out a shorter-term mortgage, while still preserving flexibility. At a time when no one knows where the economy is going, that's a real plus.
IS A 15-YEAR MORTGAGE A GOOD INVESTMENT? ADVANTAGES -- Carries a lower interest rate than a 30-year mortgage -- Enforces savings discipline -- Earns high rate of return compared with today's CDs DISADVANTAGES -- Reduces funds for equities, which pay higher returns long-term -- Limits ability to shift investments if inflation and interest rates rise -- Locks homeowner into high principal payments even if personal financial needs change DATA: BUSINESS WEEK