Borrowers Grow More Wealth with 15-year Mortgage

Longer loan term doesn't necessarily mean less cost

By Jack GuttentagInman News

Q: I can afford the larger payment on a 15-year fixed-rate mortgage, but I plan to take a 30-year anyway, invest the difference in the cash flow, and end up ahead. Is there a flaw in this plan?

A: Yes. The flaw is that the investment return required to make the plan work is much too large. You will almost certainly end up poorer than if you take the 15-year mortgage.

If 15-year and 30-year loans carried the same rate, say 6 percent--and you earned 6 percent by investing the difference in monthly payments--you would end up in the same place. Your investment return would have to exceed 6 percent to come out ahead on the 30-year loan.

Assuming 15-year loans carry a lower rate, which is almost always the case, the required return to break even rises. For example, assume the 30-year rate is 6 percent and the 15-year rate is 5.625 percent, a typical rate difference of 0.375 percent. The break-even rate would then be 7 percent over 15 years, 7.86 percent over 10 years, and 10.49 percent over five years. Very few mortgage borrowers today keep their loan for 15 years.

The calculation above assumes the interest rate is the only difference between the two loans. But if the down payment you expect to make is less than 20 percent, you will have to pay for mortgage insurance, and the premiums are higher on the 30-year loan. For example, if you put down only 3 percent and pay standard insurance premiums, the break-even investment rate is 7.49 percent over 15 years, 8.95 percent over 10 years, and 12.78 percent over five years.

All the required returns shown above were calculated from calculator 15b on my Web site.

The upshot is that a strategy of taking a 30-year loan and investing the cash flow difference between that and a 15-year loan is almost bound to be a loser. Even if you are disciplined enough to actually make these monthly investments regularly, it is very unlikely that the return will be high enough to leave you ahead. This is particularly the case if you are not putting 20 percent or more down, and if your time horizon is short.

For those who can afford the payment, the 15-year fixed-rate mortgage is a winner.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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