The following is a guest post from Stephen from The Fire Lane.
Interest rates are rising.
At the end of 2018, it is still a good time to refinance for many. Nobody can predict the future, however, it’s easy to visualize 6%+ mortgage rates in a couple of years.
If you are on the fence about a new home purchase, locking in a low rate now could save you thousands of dollars.
Wherever you are in your home ownership journey, there may be a lesson in our recent home purchase and the decision that we made.
In the fall of 2016, we took out a $287,500 loan on our new home. My wife and I weighed our loan options. Choosing between a 15-year mortgage at 2.75% or a 30-year mortgage at 3.4%.
Ultimately, we decided on a 15-year fixed loan.
Our mortgage with an interest rate of 2.75% carries a principal and interest payment of $1,951.04 per month. We’ll make 180 payments overall.
We’ve been making payments on this loan for 2 years and have had ample opportunity to reflect on our mortgage decision. There are a few things about our 15-year mortgage that we love and also a few things that we hate.
If you are considering a new mortgage consider these points as you are making the decision between a 15-year and the more standard 30-year mortgage.
What We Hate
1. The payment amount.
In 2018, our take-home income is $9,990 per month and our gross income is approximately $12,500 per month. Housing is a large portion of our spending.
The old-school rule of thumb for mortgages is to not spend more than 28% of your gross monthly income. This rule gives us a cap of $3,500.
With our $1,951.04 mortgage payment, we also consider the $830 we pay each month in property taxes and the $190 per month we spend on property insurance. Our total home payments of $3,000 are just shy of that 28% rule.
Our percentage is 24%.
A 30-year mortgage financed at 3.4% would have cost us $675 less each month. These savings would provide a much easier to budget 18.5% mortgage spending.
2. A 15-year mortgage is not flexible.
A job loss, a disability, loss-of-work, a death. All of these things would quickly affect income if they were to take place.
The payment on a mortgage is not flexible. The 15-year decision cannot be undone easily or quickly. It can also be tough to tap into home equity if you need it for an emergency.
For those with uncertain jobs, a shorter duration mortgage may be more desirable. You will lose some advantages to the shorter mortgage but gain the flexibility you need to keep you off the ropes in the event of an emergency.
Our jobs are relatively stable. Instead, we rely upon an emergency fund that can cover our home expenses if needed for a few months.
3. We could be achieving similar results with a 30-year mortgage we make extra payments on.
A 30-year mortgage at 3.4% would cost $675 less per month than the $1,950 we pay for our 15-year mortgage at 2.75%.
If instead, we had taken out the 30-year we could have sped up the mortgage. To do this we would have applied the $675 savings each month towards principal. Most mortgage lenders make this extremely easy to do through online payment portals. The process can be automated in most cases.
Tip: Related to the above comment on flexibility; This method will quickly allow you to reduce your monthly payment by hundreds of dollars in the event of a job loss or similar. If you need the income, just stop making the additional payment.
Making this extra payment each month reduces the mortgage payoff time to 16 years!
You’ll pay the same total payment amount as the 15-year mortgage but the increased flexibility will cost you more interest which slightly increases the payoff time.
What We Love
We certainly don’t hate our 15-year mortgage. These are the things that make us love the loan terms. Ultimately, they are why we decided to finance this way.
The 15-year mortgage has a place in our financial plan.
1. The amount of interest we are paying over the life of the loan.
Total interest that will be paid on my 15-year 2.75% loan will be $63,686.70.
Total interest paid on a 30-year 3.4% loan would be $171,503.08.
That’s right. The numbers do a great job of speaking for themselves. A 30-year loan could easily cost 3 times the 15-year in interest fees. Who wants to make a bank rich?
As interest rates go up, which they most certainly will, these interest numbers are going to get larger.
At today’s 30-year 4.76% average rate, the loan would cost you $253,029.02 in interest payments. Look at what that extra 1.36% means. How many years of additional work is that?
2. The Forced Savings which comes with a mortgage.
That same lack of flexibility stated above allows us to save in the ultimate forced savings account.
Each month we pay off the principal on our loan. If we assume a level or increasing real estate market we are increasing our equity in the home. Eventually, we should fully own an asset worth over a half million dollars.
Today we are paying $1,365 per month towards principal. That’s $16,380 saved each year. But, this savings amount goes up each month as the loan amount is reduced. In 3 years we will be paying the mortgage down $17,800 per year.
On a 30-year mortgage, the amount going towards principal would be $492 per month or $5,900 per year. The 15-year mortgage allows me to save $10,000 more per year.
Tip: This can be a good tool for those that have bad self-control when it comes to tapping savings. Principal in a mortgage is illiquid and difficult to get at. It’s tough to spend your home equity on a new motorcycle or other materialistic purchases.
3. We won’t have a Mortgage Payment in retirement.
I believe the 30-year mortgage, as it’s designed to be paid, is too long a period for anyone to reasonably consider. The average age of most first time homebuyers is 31. A 30-year mortgage has them handcuffed to the payment until the age of 61.
Our 15-year mortgage, taken out at the age of 34 will mature when I am 49.
Not having a mortgage payment allows us the flexibility to do the following:
Retire early. We’ll have $2,000 less each month in required spending which reduces retirement expenses massively.
Trade down and pad our nest egg. We could sell the home and downsize to something smaller (and pay cash from proceeds). The difference in value could help add hundreds of thousands to our nest egg immediately.
Sleep better. Loans = Risk. Even if the perceived risk is small it is still there.
Did We Choose Correctly?
The loan decision is very personal. Weigh for yourself the pros and cons before accepting the standard 30-year fixed rate loan. But, do not make the decision solely on the monthly payment.
If our jobs were riskier I would have opted for the larger timeframe loan with increased payments. But for us, the positives of the 15-year mortgage outweighed those of the 30-year.
We chose correctly for our needs.