Why a 30 year loan is often better than a 15 year loan?
As I am nearing my house purchase closing date, I am increasingly swayed by different data points to decide between two mortgage loan choices – a 15 year term and a 30 year term. In short, 15 year term offers lower interest rate, overall quicker growth in equity and less interest payment overall. On the other hand, a 30 year term offers more affordability and it is easier to manage since the monthly payments are significantly lower.
To compare these two term, I would lock the interest rates I have been quoted by one broker as 2.85% and 3.75% respectively. At the same time, I would lock the principal amount to be at 417,000$, above which the loan becomes “Jumbo” and calculations vary significantly. Now, assuming that you have affordability to pay either (i.e. can pay 15 year monthly payment from your income), I would like to discuss which one is the better option. If your affordability doesn’t help, I believe 15 year is a non-option.
First, I would like to calculate the payments and interests paid. The site taxprofessors helped me a lot in this. The net comes to something like this -
|Loan Term||Monthly Payment||Interest||Months|
At this point, it seems inevitable that you should go for a 15 year loan instead of a 30 year one. But I am already assuming that both 15 year and 30 year terms are equally affordable to you. So, you are left with 918.54$ extra at the end of each month. How about re-investing it into the loan in order to match the data “apples-to-apples”? That’s when principal prepayment comes into the equation. Now, if I use a principal prepayment of 918.54$ each month, we equate the first column in the above chart. The new terms are -
|Loan Term||Monthly Payment||Interest||Months|
|30 Year with Prepayment||2,849.74||141,197.12||196 (-164)|
So, on a 30 year term, you get to pay around 45,244$ more than your 15 year counterpart. Isn’t that still big? Not as big as you think if you consider the tax and inflationary savings. If you are in 25% tax bracket for next 15 years, you get to save ~11,000$ overall in the loan period. The actual calculations are a little more complicated and hence I am taking help of calxml.com mortgage tax savings calculator. Assuming a 25% tax bracket, let me compute the tax savings as mentioned by the website -
|Loan Term||Interest||Months||Tax Savings|
|30 Year with Prepayment||141,197.12||196 (-164)||51,477|
Now the net tax-adjusted difference between the two loan terms becomes 17,755$ – even lower than what we were expecting. Of course this one assumes that one would be fully itemize the deductions. With a property tax, it’s often easier to claim itemized deductions (ahead of standard deductions currently @ 11,900 per married couple) in 30 year term than the 15 year counterpart. The scenario will require even more complicated table but the apparent tax gains due to 30 year loan should shorten because of that. On the other hand, you can always free to add more stuff on top of your itemized deductions in order to balance it towards 30 year term.
Moreover, the extra payment we make at the end of year 15 on wards for 16 more months in case of prepayment based 30 year term – is subjected to inflationary changes. The 2849.74$ per month I pay now will not be as “valuable” as it will be in 15 years because, prices of everything will go up and so would the salary. Considering historical data in USA, I see the value of 100$ in 1998 is now 141.28$, i.e. an inflation of 41.28%. Assuming the same to happen in next 15 years, the apparent 45,244$ gap will not be that intimidating. The inflation adjusted figure is only 32024$.
If we try to merge last two sections (mathematically wrong though, just to show you), we get a tax-inflation-adjusted figure of 12567$. If I remove all irregularities, I would probably get a value of $15,000 in current dollar value. So, the difference between 15 year and 30 year loan is basically $15,000 (i.e. 3.5% of the principal) !!
So, you are paying just 15,000$ more to get much more flexibility, i.e. lower the payments for a few years when your wife decides to get off from job and join a University course. You can always pay it back later and chances of getting foreclosed is much less. Also, you avoid a costly refinance if your income suddenly comes down or you lose your job.
Let’s not forget the catch, the 15 year loan still gets you to add equity faster. So, if you are planning to sell your house off midway, expect to incur a loss, but again that loss is adjusted with tax and inflation. Let’s see it in the next table -
|Loan Term||5 year principal||10 year principal||15 year principal|
|30 Year with Prepayment||101,892.32||224,761.94||372,927.71|
I understand we all are different human beings and need to be treated differently. So, get to the tools and links I provided and get your calculations done. You can always comment on what you have found out for yourself.
Note – Another site that provides you with detailed data is this one.