Locking in your Mortgage Rate? A 15yr vs. 30yr & Financial Analysis

Locking in your Mortgage Rate?

A 15yr vs. 30yr & Financial Analysis

After several years of historically low interest rates, May 2013 saw a slight uptick. At the same time, some data showed home prices starting to rebound as well. For both prospective home buyers and current homeowners, this may indicate a closing window of opportunity to secure a favorable mortgage. Besides locking in a low rate, borrowers will also be considering: Is a 15-year or 30-year mortgage better for my situation?

Assuming you can afford the monthly payments for either option, conventional financial wisdom favors the 15-year option, simply because it greatly reduces the amount of interest paid over the term of the loan. On a $250,000 loan at 4%, the numbers seem compelling:

                                           OPTION 1                                 OPTION 2

                                      15-yr mortgage                        30-yr mortgage

Mortgage amount:             $250,000                                   $250,000

Monthly payment:             $1,849.22                                  $1,193.54

No. of payments:                   180                                             360

Total payments:              $332,859.60                               $429,674.40

Interest payments:         $82,859.60                             $179,674.40

Choosing a 15-year mortgage means a 54% higher monthly payment, but a 30-year mortgage results in 116% more interest paid. If you can afford the higher payment, the 15-year mortgage is the way to go, right? 

But wait…there’s more to consider.

What if the borrower selects a 30-year mortgage, and deposits the difference in monthly payments into an accumulation account?

$1,849.22/mo. - $1,193.54/mo. = $655.68/mo. deposited to acct.

At a later date, the borrower uses the accumulated savings to pay off the mortgage early. Using the same $250,000 mortgage, and assuming the annual rate of return on accumulated funds is also 4.0%, guess what? The outstanding balance on the 30-year mortgage after 15 years is $161,000, and the accumulation account has grown to $161,000. If the borrower chooses, a simple transfer can pay off the loan.

Because the amount borrowed, interest rate, and total monthly payments are equivalent, the outcome is the same using either strategy; the house is free and clear in 15 years. However, choosing Option 2 provides some additional benefits, both mathematical and practical.

• With the 30-year mortgage, a borrower pays $126,193 in interest over 15 years. On a 15-year mortgage the total is $82,859. If the homeowner is able to itemize deductions, Option 2 means 52% more deductible interest.
• A household that can afford Option 1, but selects Option 2, has a lower risk of default and loss of the property. First, the lower payment is less of a burden on monthly finances. Second, the accumulated funds can be used to make the mortgage payment in the event of a complete loss of income.
• Some or all of the side accumulation can be easily accessed from Option 2 if another financial opportunity arises. With the 15-year plan, the “accumulation” is equity in the home. If the individual wants to tap this equity, a home equity loan is required. This transaction is subject to a lender’s approval, and usually requires a monthly repayment.

So…all things being equal, the best approach may be to take the 30-year mortgage, save your “extra” principal payments in a separate account, and pay off the mortgage in a lump sum. This strategy will not only pay off the mortgage just as soon, but also give you greater access, flexibility, control, and tax breaks for your money.

Yeah, but…

Thirty-year mortgages typically have higher interest rates than 15-year offerings, as lenders see more risk with the longer time frame. And whether or not a separate accumulation account can deliver returns equal to the mortgage interest is also problematic. What happens if the comparison is skewed to reflect these realities?

On May 31, 2013, bankrate.com quoted 30-year fixed mortgages at 4.0 percent and 15-year mortgages at 3.3 percent. At 3.3 percent, the monthly payment is $1,762.75/mo., which means the monthly difference between a 30-yr fixed at 4% is $569.21/mo. (as opposed to $655.68/mo. in the previous all-4-percent example). Let’s also assume the saving earns only 1%, reflecting the current low rates for conservative interest-bearing accounts.

The combination of the smaller amount available to be saved and a lower rate of return on the deposits means there will not be enough accumulation to pay off the 30-year mortgage in 15 years. After 180 payments, the 30-year mortgage has an outstanding balance of $161,357. The accumulation account has $110,584, a gap of $50,773.

So…“real-world” calculations support taking the 15-year mortgage?

Not necessarily.

Even under these circumstances (smaller monthly saving amount, lower return), the $50,000 gap can be eliminated in 216 months – just three more years. Is this a bad trade-off for the tax, accessibility, flexibility and control benefits that come from establishing a side account?

And…Since it appears that interest rates are rising toward their historical averages, what is the likelihood that returns from the side account might also increase? If the annual rate of return on savings were to jump to 6%, the 30-year mortgage could be paid off in 14 years, 8 months!

Although the numbers are relevant, these projections (for and against either option) can’t be considered persuasive.

Ultimately, the real issue is the value you place on having personal control over your financial actions.

If the goal is to pay off a mortgage in 15 years, the straightforward solution is to select a 15-year mortgage and allow the lender to set the terms; this is the interest charge and this is the monthly payment. But if a lender is willing to offer other, less-restrictive terms (a 30-year mortgage with lower monthly payments and no penalty for early payoff), those who value financial control should take a long look at the possibilities that might arise from taking the longer term and developing an additional source of savings.

By the way…

Extra thought #1: From this discussion, it is possible to make another practical application: If you can afford a 15-year mortgage, choose a 30-year – and save the difference. If you can’t afford a 15-year term, selecting even a 30-year mortgage is a bit of risk, because you may not have additional savings to ensure your ability to make future payments.

Extra thought #2: Making extra principal payments each month on a 30-year mortgage will also result in paying off the loan earlier, but is not the same as accumulating in a separate account. The extra principal adds to the home’s equity, but the only way this additional “savings” can be accessed is by approval of the bank through a home equity loan.

Extra thought #3: Finding the appropriate financial instrument(s) for your savings is a key component in successful execution of this strategy. A financial professional should be able to provide several options, taking into consideration potential return, accessibility, and tax consequences.

If you would like to discuss this article please feel free to contact me...

Respectfully,  

Harry C. Brousaides, Jr. / Financial Representative / The Bulfinch Group

160 Gould Street, Suite 310, Needham, MA 02494

Office: 781-292-3238 / Cell 508-451-5840 harry_brousaides@bulfinchgroup.com

Registered Representative of Park Avenue Securities LLC (PAS). Securities products and services offered through PAS. Financial Representative, The Guardian Life Insurance Company of America (Guardian), New York, NY. PAS is an indirect, wholly owned subsidiary of Guardian. The Bulfinch Group is not an affiliate or subsidiary of PAS or Guardian. Life insurance offered through The Bulfinch Group Insurance Agency, LLC, an affiliate of The Bulfinch Group, LLC. The Bulfinch Group, LLC is not licensed to sell insurance.

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