This post is from a new FiscalGeek staff writer: Kevin Mercadante. I’m very excited to have him contributing to the site. You can find out more about him at his own blog OutOfYourRut.com.
Last week on Fiscal Geek we asked the question, Is There Such a Thing as “Good Debt?” and advanced the idea that debt is debt, and none of it is good.
As we discussed, mortgages are not good debt, but since so few people are in a position to pay cash for a home, they may be better referred to as necessary debt. That is to say, we should take them only reluctantly, under the most conservative of terms, and with an intention and a plan to pay them off as soon as possible.
Many people believe that by taking a 15 year mortgage they are taking a more conservative loan and perhaps more importantly, they’re implementing a plan to pay it off as soon as possible. While that may be true, a 15 year mortgage carries more risk to the homeowner than a 30 year loan does.
The greatest strength of a 15 year mortgage is also it’s greatest weakness
The primary advantage of the 15 year mortgage is that it cuts the time to pay it off in half compared to a 30 year loan. That’s a huge advantage, no doubt, but it does come with a major downside and the risks attached to it.
The entire reason a 15 year loan cuts the term is because the borrower is making a higher payment. Yes, you will eliminate the loan in half the time, but you’ll be making seriously higher payments until the loan is paid—and 15 years is a long time when you’ve got other expenses competing for your budget dollar.
All of the advantages of a 15 year loan are at the very end, when the loan is finally paid off. However for 15 years you’ll be making a monthly house payment that will be substantially higher than it would be under a 30 year term. You will be locked into that payment, since accelerated principal payments reduce the balance of the loan, but not the monthly payment.
If your financial situation remains constant for the entire term of the loan, it will have been a choice well worth making. But what if that isn’t the case?
In today’s economic climate, how unusual is a job loss, or a job loss resulting in a newer job at lower pay? Will you still be able to afford the higher payment should the worst happen? Compounding it is that you won’t be able to refinance your 15 year mortgage into a 30 year loan if you’re unemployed. The loan that fit so nicely in your budget when you were fully employed could become an unserviceable nightmare in a career crisis.
A funny thing happened on the way down to lower rates
Back in the 1980s, when refinancing into 15 year loans became popular, the high rate environment made the transition easier. Going the 15 year route in a market with double digit rates made obvious sense. By paying just a little bit more each month, the loan term would be cut in half.
On a $100,000 at 12%, the monthly payment would be $1029, while a 15 year loan at 10% gave a monthly payment of $1075. The difference between the two loans is $46 per month, or about 4.5%. Who wouldn’t take that deal?
But as we’ll see, that’s not the situation today.
With reasonable closing costs, you can now get a 30 year loan at around 5% even. But spreads between mortgage types have narrowed considerably and the rate advantage going from a 30 year loan to a 15 is measured in fractions of a point. Thus a 15 year loan now runs around 4.5%.
Due to the rise in home prices, we’ll work with a $200,000 loan balance. A 30 year loan at 5% is $1074 per month; a 15 year loan at 4.5% is $1530 per month. What happened to our small price differential ???
In today’s rate environment, taking a 15 year loan results in an increased payment of $456 per month! That’s an increase of well over 40% in the monthly payment and might require rearranging your entire budget. The reason this is so is because in a lower rate environment, principal payment becomes more significant than interest rates!
Without a doubt, there will be significant benefits to paying your mortgage off in 15 years versus 30, but as you can see from the comparison, it will cost you plenty in the meantime—with the meantime being, oh about 15 years. That’s a long time to be locked into paying an extra $456 month—a really long time. Lose your job, and it’ll seem even longer!
A flexible solution
None of our financial decisions can be made in a vacuum. We always need to consider that the course of events won’t be within the scope of perfect world assumptions. No matter how noble and well conceived our plans, in the real world we need to keep our options open and remain as liquid as possible.
Along that line, my suggestion is that you take a 30 year loan, but pay it as though it were a 15. Using the above example of a $200,000 loan, in order to pay it in 15 years, you’d have to increase the payment from $1074 to $1582—an increase $508 per month.
Pretend that IS your payment and make it faithfully. However, in the event of a job loss or other financial emergency, you can easily drop back to the original scheduled payment of $1074—at least until your situation improves—and that’ll free up a whole lot of cash flow in a crisis.
In the last few years of my career as a mortgage originator, I began getting increasing calls from people wanting to refinance back into 30 year loans, after only a year or two with the 15s. It quickly became apparent to many that the cost of the 15 year mortgage, month in, month out, was too much to carry.
Paying off your mortgage early is a good thing that should be pursued purposefully. But locking yourself into the process may box you into a corner at the worst possible time.
What do you think about 15 year mortgages? Have you or anyone you know taken a 15 year mortgage and paid it off without refinancing? What did you do when a financial crisis hit?
Photo courtesy of woodleywonderworks