Doing the Math: 15 Year vs. 30 Year Mortgage & Investment Options
Many Americans (including myself) have been brought up on the notion that one of the first major steps to adulthood and personal wealth is home ownership. While this notion may be changing in today's world of rising housing costs, stagnant wages, and changing attitudes towards asset ownership, it is still important to gain an understanding of how mortgages work so you can make the right financial decision if and when the time comes for you to buy a home or invest in real estate.
Here are some things to know before we jump into the math:
Home purchasing is a serious commitment, and you should weigh all the qualitative and quantitative aspects before taking out the largest loan of your life for a principal residence or an investment property.
A monthly mortgage payment depends on 3 things:
The amount of money borrowed (the principal amount),
The interest rate paid on the money borrowed, and
The term to pay off the principal amount
In more expensive markets, having a 15-year loan can be prohibitively expensive due to the higher monthly cost, but many people advocate for 15-year loans to eliminate debt faster and put a stricter limit on the amount of house the buyer can afford. Because of these limitations, this analysis may not directly apply to everyone, but everyone can learn from it to make more informed and educated financial decisions in the future.
Key Assumptions and Information:
15-year mortgage rates will be lower than 30-year mortgage rates because they are less risky to the lender due to a shorter time horizon.
You have a 20% down payment to put towards the property to avoid PMI (Private Mortgage Insurance)
The house will not be sold over the 30-year term.
You can afford the 15-year mortgage payment.
You invest any excess funds into the stock market for a (fairly conservative for the sake of this example) 7% annual return and will keep the fund proceeds reinvested from the date of the investment through the 30-year return.
The last two points noted above are the key assumptions for the math problem below. In the current market many people may not be able to afford a 15-year mortgage because it is prohibitively expensive and some investment advocates would argue that if you cannot afford a 15-year mortgage with your other expenses, you cannot afford to buy the property. This model assumes that you can afford either a 15-year or 30-year loan, and are willing to invest the difference in the payments. What this means is that when all is said and done, the out of pocket cash paid will be the same for both cases.
As we can see, investing the difference in the stock market over time provides a significant return through the power of time and compound interest. Even though the same amount of cash is expended in both cases, the 30-year mortgage ends up with a more valuable investment portfolio because it got started earlier in the market. Bear in mind that this model assumes the property will be held for the 30-year term and therefore there would be no difference between the two scenarios regarding the remaining mortgage to be paid off at the time of sale.
If you are interested in seeing the full loan amortization schedule and some key statistics, download the spreadsheet here. If you have any questions or want to know more about a certain small business or personal finance topic, please email us at scalefinancialeducation@gmail.com.