The ’15-year vs. 30-year’ mortgage debate has been rolling on for years, focused primarily on the total interest saved by opting for the shorter term. Whether buying a first home, refinancing, downsizing, or buying the dream retirement home, there is an impulse to choose the shorter term when affordable.
The argument has plenty of good math involved, and we’re down for that:
A 30-year loan for $350,000, with an interest rate of 3.5% and minimum monthly payment of $1,572, comes to a whopping $215,796 in total interest paid – that’s like another house!
If the same loan were paid off more aggressively over 15 years, with a monthly payment of $2,502, the total interest paid would be $100,376 – a huge reduction of $115,420.
“But wait – what about the lower interest rate when choosing the shorter term?”
Okay, let’s do that math too:
A 15-year loan for $350,000, with an interest rate of 3.0% and minimum monthly payment of $2,417, comes to a $85,066 in total interest paid – an improvement of $15,310 vs. choosing the 30-year mortgage and paying it off aggressively in 15 years.
From a completely objective, math-driven analysis, taking on the 15-year mortgage is a no-brainer.
BUT you are the type of person who wants to think about their money in terms of risk – good for you!! Having the 15-year mortgage is fine and dandy, until life happens. Job loss, disability, medical bills, and increased lifestyle expenses can all derail the path to financial independence – particularly if you are highly leveraged with an illiquid asset (more like liability) in your primary residence.
So, how do we solve for uncertainty in our financing decisions?
We use the Mortgage Flexibility Calculator!!
Using this handy tool, we can see that the 3 mortgage options discussed each have their own benefit – the 15-year mortgage has the lowest interest and the 30-year mortgage has the lowest monthly payment, but a hybrid provides us with cash flow flexibility.
If you choose the 30-year mortgage but plan to pay it off in 15 years, your monthly payment of $2,502 vs. choosing the basic 15-year mortgage at $2,417 is increased by 3.5%. Sounds like a bad deal until you realize that you now have the flexibility to reduce your minimum payments down to $1,571 when expenses tighten. This allows an additional $845 of available monthly cash flow.
During a major economic downturn like we’ve seen with the COVID-19 pandemic, this flexibility to reduce monthly payments has significant value. It provides the ability to slow down during times of stress and income uncertainty without the added risk of missing payments and defaulting on the loan.
As seen on the calculator above, this flexibility to reduce monthly payments comes at a premium – like paying for insurance. The cost of flexibility for this example is $85 per month, or about 4% of the initial mortgage amount on an annual basis. Keep in mind that every mortgage finance scenario is different, and this cost of flexibility may be higher or lower when calculating your options. This is also separate from the ‘invest vs. pay off debt’ debate.
I hope this concept and additional tool provides value and adds another depth of clarity to your financing decisions.
If you would like a free copy of the Mortgage Flexibility Calculator (Excel), simply download here!