Disclaimer: I am not a mortgage lender, accountant, or financial advisor. I’m a professional real estate consultant that is passionate about the subject and likes to think outside the box. I, in no way, recommend you make investment or lending decisions based off the content of this writing. It is intended only to open your mind to other possibilities, which I strongly advise discussing with your mortgage, tax and financial professional.
So you’re shopping for a mortgage. You’ve saved, and researched, and the conventional wisdom says “if you can, get a 15 year mortgage!”
After all, you’ll save thousands in interest via the shorter life of the loan, and you’ll be mortgage free sooner! Plus, interest rates are typically lower for 15 year notes, saving you even more, right?
This advice isn’t necessarily wrong, and, as I often tell my clients, real estate isn’t always black and white. There are many ways to leverage it to your advantage, and this topic is no different. So today, I’m making the case for a 30 year mortgage over its 15 year counterpart. I’ll lay out the reasons I often advise that my clients explore this strategy with their mortgage lenders and financial advisors prior to securing a mortgage loan, along with some real-world examples. I’ll also examine the strategy from the perspective of a typical buyer, as well as a real estate investor.
Let’s dig in. First, let me lay out the typical case FOR the 15 year mortgage, before I examine the alternative:
Interest Savings
This is the obvious one, and so I’ll start here.
Because interest is paid monthly, for the life of the loan. It stands to reason that when comparing two loans, with the same principal balance and interest rate (more on this in a moment), but with one having half as many payments during its life than the other, the one with the shorter life will net significant interest savings.
For example, let’s say we have two loans with a principal balance of 100K at 3% interest. One is spread over 360 payments (30 years) and the other 180 (15 year). I ran an amortization and below is the summary:
30 Year Note:
Interest paid over life of loan: $51,777
Monthly principal and interest payment: $421
15 Year Note:
Interest paid over life of loan: $24,304
Monthly principal and interest payment: $690
On first examination, you’ll see that with the 15 year note, you are saving $27,473 in interest over the 30 year option, while borrowing the same amount of money, which is excellent. Because you are condensing the principal into a shorter time period, your monthly P&I comes in about $269 higher. Granted, you’re paying off the same principal balance, so this isn’t an added cost per se, but it is a larger monthly obligation (more on that later).
Lower Interest Rate
Historically, 15 year notes have carried a lower interest rate than their 30 year counterparts. The difference varies, but often this is in the ball park of .5-1%. If we adjusted the interest rate for the 15 year note on the example above to 2.5%, the scenario now looks like this:
15 Year Note:
Interest paid over life of loan: $20,022
Monthly principal and interest payment: $667
Now, you’re saving $31,755 for an increased monthly obligation of only $246 during its repayment period. Nice!
Shorter Repayment Period
Now I’ll be captain obvious for a moment. 15 years is half as much time as 30 years. Who doesn’t like to be debt free? Aside from saving money, the obvious appeal to a 15 year mortgage is being mortgage free sooner.
OK…. I know what you may be thinking; a 15 year mortgage sounds great – I’m sold! But, wait. Here is where you can get creative. Let’s get to the meat of the topic:
The Case for a 30 Year Mortgage
Opportunity Cost
Remember this one from your college finance class? Investopedia defines opportunity cost as “the forgone benefit that would have been derived by an option not chosen.” In the example above, we came to the mathematical conclusion that the 15 year note would save you approximately $31,755 over the loan’s life, with an increased payment obligation of $246 for those 15 years. Imagine you went with the 30 year note and instead invested that $246 monthly at an average rate of return of 7%, which is achievable (remember, the stock market historically averages around 10%). At the end of 15 years, your side investment would be worth approximately $78,000. At this point in your 30 year mortgage, the loan payoff would be approximately $61,000, meaning you could take your investment profits and pay off your 30 year mortgage at year 15, having spent the exact same amount monthly for the past 15 years as the 15 year note, and be left with a profit of $17,000.
Now, of course, I’m generalizing here. There will be some taxes on your investment earnings, reducing that profit some. But, with the right investment, perhaps you achieved a rate of return higher than 7%.
You see where I’m going with this.
You leveraged a 30 year note to achieve a lower total mortgage payment, invested the difference, paid the note off at year 15, and made additional money on your investment, besting the 15 year mortgage by thousands of dollars to your advantage and still becoming mortgage free in the same amount of time. Cool, right?
Yes, this strategy takes discipline, assumes some risk, and is just one simplified example of how you could capitalize on this. Most importantly, it still leaves you with flexibility, should times get tough.
Payment Flexibility
2020 is a perfect example of why payment flexibility during times of financial stress and uncertainty is worth its weight in gold (or mortgage interest savings). Imagine you bought a house in 2019. Times were good, your job was secure, and the 15 year mortgage seemed like a no brainer for the interest savings over time. Then, the unthinkable happened. Fast forward one year and the COVID-19 pandemic has cost you your job. You picked up new work where you could, but it’s at a fraction of your previous earnings. Suddenly, the last thing on your mind is the potential of savings over decades, or being mortgage free in another 14 years. Your focus is now undoubtedly on paying the mortgage next month, avoiding foreclosure, and keeping a roof over your family’s head. While no one hopes for this situation, it is the sad reality for thousands, if not millions of families affected by the pandemic. That extra $246 a month could be the difference between paying the mortgage at all, or the electric bill, or even groceries and basics, and you might be glad for the lower payment, if you had chosen it.
The 30 year note gives you flexibility to use that money other ways when you need it most. And while we’re on the subject of flexibility, here’s another interesting tidbit to note – if your income recovers and times are better, you can still shorten that 30 year mortgage and save thousands on interest, all without refinancing! How? I’m glad you asked. It’s EASY.
Ever heard of a pre-payment penalty? If you’re a Baby Boomer, or maybe even Generation X, you may have. If you’re a Millennial or Generation Y, you probably haven’t. That’s because they largely don’t exist anymore. A pre-payment penalty is a fee some lenders charge if you pay some or all of mortgage obligation early. It’s supposed to incentivize you to pay the principal back slowly so that the lender doesn’t lose out on collecting all of that glorious interest. The fact that they are largely extinct means you can dial up your principal payments when times are good in order to shorten your mortgage and save on interest.
Bankrate.com has a handy calculator that you can use to see the effect of extra principal payments on your mortgage. You can find it here. Using the example we’ve been referencing throughout this post, if you were to make an extra $100 monthly principal payment, from month one, you would shorten your mortgage loan by 8 years and 2 months and save about $15,000 across the life of the loan. How’s that for flexibility?
What if you’re an Investor?
So, what if you’re an investor? Well, all the same benefits apply, and there are some additional considerations as well.
Because your tenant is generally covering the debt service, the $246 lower monthly payment for that first 15 years is passed on to you in the form of increased margin. You can do many things with it. Perhaps you could use it to pay down the principal on a higher interest mortgage loan in your portfolio (remember you can shorten your repayment period and save thousands on interest with extra principal payments), or you could invest it, either in financial instruments or additional real estate.
This last point should not be overlooked. If your goal is to continue scaling your real estate portfolio, consider that a 15 year note has a greater impact on your debt-to-income ratio and that lenders may take into account that the cash flow won’t be as strong when considering market rent. Taking this a step further, consider that, in most cases, a 20-25% down payment is required to purchase investment property, and that increased cash-flow may help you acquire more real estate faster, the cumulative effect of which should exceed any interest savings realized by the 15 year note, assuming you make wise selections.
Finally, remember that as an investor, your goal, at a very basic level, is wealth building by having someone else pay the mortgage in exchange for living in the property. If turbulent times were to cause rents to dip significantly, there is always a possibility that rents don’t cover the full debt service (not to mention taxes, insurance, vacancies, etc…) With a 15 year note, there is less margin (literally) for error, at least initially, which can make it higher risk.
Conclusion
The concepts in this article are simplified and quite condensed, which is intentional. As I was writing, I resisted the urge to spinoff on numerous tangents. Of course there are numerous other factors to consider; tax implications, investment strategy, market conditions, risk tolerance, the list goes on. All in a boundless number of combinations, which is what makes real estate both thrilling and complex.
For many, a 15 year mortgage might be an excellent selection, and I don’t want to downplay its direct benefits, but I hope reading this opened your eyes to the exciting possibilities of real estate and how all is not always as straightforward as it seems.
