We’ve all been told that when comparing the 15 vs 30 year mortgage, that the 15 year option is superior since you will save thousands of dollars in interest. The banks make you think that this is in your best interest, but often times it is not.
SAVING INTEREST IS NOT THE SAME THING AS MAKING MONEY!!!
The idea of saving interest is certainly very appealing, but it should not be confused with making money.
So, if you are purchasing a home or even refinancing your existing mortgage, don’t automatically assume that a 15 year mortgage is best. While it’s true that you will possibly save thousands of dollars in interest, you may actually be leaving a lot of money on the table.
This concept is based on Opportunity Cost, which I wrote about in Should You Pay Off Your Mortgage Early. In that article, I discussed that paying extra toward your loan could actually cost you thousands if not hundreds of thousands of dollars. The same concept applies when comparing the 15 vs 30 year mortgage.
With a 15 year mortgage you have a higher monthly payment than you would with a 30 year mortgage. So, you are essentially paying extra each month to pay off the mortgage sooner. When you do this, you lose the “opportunity” to invest that extra money instead. Let’s look at an example:
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Assume that you plan to purchase a $250,000 house. You desire to put down 20%, leaving you with a mortgage balance of $200,000. Now you’re faced with deciding between the 15 vs 30 year mortgage.
If you go with a 15 year mortgage, you could expect your interest rate to be around 3.25% in today’s environment. This would result in a payment of $1,405 per month. All in total you would pay $52,961 in interest.
If you go with a 30 year mortgage, your interest rate would be around 3.875%. This would result in a payment of $940 per month. With this option, you would end up paying $138,571 in interest. That is a whopping $85,610 more than the 15 year mortgage and is the reason why so many people choose the 15 year option.
THERE’S MORE TO THE STORY
But, there’s more to the story. The 30 year mortgage costs you $465 less per month than the 15 year mortgage. This is where Opportunity Cost comes into play.
If you go with the 30 year mortgage and invest the $465 difference per month over the next 30 years at a 7% investment rate of return, you will end up with an investment valued at $570,428.
I know what you’re thinking, because we hear this all the time. You’re thinking, “But if I go with a 15 year loan, my loan will be paid off sooner and then I can start investing the full amount that I was paying for the 15 year mortgage”. In this example, after your mortgage is paid off in 15 years, you could invest $1,405 per month for the next 15 years. At the end of the total 30 year period, you would have an investment valued at $448,037, which is $122,391 less than the investment created under the 30 year mortgage. So, even though you would pay less interest with a 15 year mortgage, you lose out on the opportunity to grow your wealth by $122,391.
Hopefully now you can see that saving interest is truly not the same thing as making money!
TIME IS MORE IMPORTANT THAN AMOUNT INVESTED
This example highlights the really important point that time is usually much more important than amount invested. As we saw in the example, 3x as much was invested per month under the 15 year option ($1,405 vs $465). But it was invested for only 15 years. Investing a smaller amount ($465 per month) for a longer period of time (30 years) results in much more wealth created than investing a larger amount ($1,405 per month) for a shorter period of time (15 years). So, for all you out there who think that investing a small amount at a young age won’t pay off; think again!
WHAT IF MY INVESTMENT DOESN’T EARN 7%
And by the way, in case you were wondering, the breakeven investment return is around 4.75%. This means that if you earned only 4.75% on your investment then it really wouldn’t matter whether you chose the 15 or 30 year mortgage if Opportunity Cost were your only factor – see below. Said another way, if you think you can earn more than 4.75% on your investment, then the 30 year mortgage is likely the superior option.
The next time you are faced with deciding between the 15 vs 30 year mortgage, don’t automatically assume that the 15 year option is superior just because you’ll save a boat load in interest. As you saw, there is more to the story!!
And if today’s article wasn’t enough to convince you of the power of the 30 year mortgage, then hopefully you’ll consider these other reasons why a 30 year mortgage may be superior.
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