Is a 15 Year Mortgage Financial Suicide?

15 Year Mortgage

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in Mortgage

Kevin At Out of Your RutThis 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

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{ 36 comments… read them below or add one }

Kristia@Family Balance Sheet 2010/03/18 at 4:21 am

We have a 15 year mortgage and we will even be able to pay it off early. We have re-fi’d a few times over the years, but the biggest reason why we will be able to pay it off early was b/c we didn’t buy too big of a house. We bought a little below what we could afford at the time and that has put us in a good position over the years. We bought our house before we had kids and now that there are four of us instead of two it sometimes feels a little cramped. But hubby and I have made a commitment that we will stay in this house; there are so many things that we like about it and the mortgage is number one.
.-= Kristia@Family Balance Sheet´s last blog ..Chicken Corn Soup =-.

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kevin 2010/03/18 at 4:53 am

Kristia – You did the single biggest and best thing you could, which was to buy a house that was within your budget. The biggest mistake people make is over extending themselves on the house and what they don’t realize is that all other expenses in life will be comensurately higher–utilities, maintenance and repairs, furnishings and even autos! Congratulations on paying the loan off.
.-= kevin´s last blog ..Save for Retirement Now or Payoff Your Mortgage First? =-.

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paul 2010/03/18 at 7:44 am

Way to go Kristia! Myself I think the 15 year mortgage is fantastic if….. you do not buy too much house like you have said. Get that mortgage paid off and be done with that. That being said, I have a 30 year mortgage myself because our payments would crush us if we had taken out a 15 year with our old consumer debt. Now that we are in a different position we’ll be making almost double payments towards our mortgage come October. I just think our culture has somehow adopted the philosophy that a mortgage has to span your entire adult working life and I wholeheartedly disagree and plan to buck that trend as quickly as possible.

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JoeTaxpayer 2010/03/18 at 8:27 am

Where to start?
The spread between 30 and 15 yr rates has always run about 1/2% with little variation. You might have been looking as rates fell, so when one had a 12% 30 yr loan and the 15 yr was 10% as that happened. Even a few years into that 30 year mortgage, it might have been a small amount extra to slide over to the 15. If you play with spreadsheet, you’ll note that at higher rates, the payment delta is less going to 15 than at lower rates, e.g. @ 12% a 15yr (payment) is about 17% higher than the 30 but at 10% it’s 22% higher and at 6%, 40%.
One strategy is to start with a 30, and once things settle down, decide if you can pay ahead, and eventually take advantage of the lower rate the 15 might offer.
There’s also a line of reasoning that suggests you buy as much house as you are comfortable to pay for based on the 15yr. A gross income of $60K should be able to make the $1265/mo payment on a $160K mortgage. This is a $200K house with 20% down.

We bought knowing we planned a baby and the cost that would bring. So the path we took was to go 30 yr 7.625%. After 3 refis, we have 7 yrs left on our 15 yr mortgage at 5.24%. For the first 5 years, the nanny cost was nearly as much as the mortgage. Once our daughter was in school all day, it was easy to put the mortgage acceleration into full gear.

I’d say there’s no right or wrong, just what works for the individual, each person having their own priorities.
.-= JoeTaxpayer´s last blog ..Another look at the Roth IRA =-.

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Kevin@OutOfYourRut 2010/03/18 at 10:21 am

Joe, actually the 30/15 yr spreads were that wide in the 1980s. Spreads narrowed since the 90s due to factors beyond this thread.

That’s a great idea buying a house you can comfortably afford on a 15 yr loan. Guaranteed the mortgage meltdown wouldn’t have happened had everyone been doing that!

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Jackie 2010/03/18 at 1:12 pm

I’ve had 30, 20, and 15 year mortgages, and haven’t paid any of them off (yet!) except by moving. I think many people who compare 15 and 30 year mortgages choose the 30 year for exactly the reason you mention: they can make the higher payments to pay it off early but aren’t locked in to doing so. Often they end up not doing what they’d intended to.

I’d argue that if you want to pay off a mortgage in 15 years, you shouldn’t borrow more than you can comfortably pay each month even *with* emergencies. Emergency funds are for emergencies, not mortgages.
.-= Jackie´s last blog ..What’s Holding You Back? =-.

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kevin 2010/03/18 at 5:12 pm

Jackie – you’re emphasizing a theme that Kristia mentioned earlier, about not buying more than you can afford. All things are possible when finances are in control.

It’s so true that we indend to do good things, then somehow we get sidetracked. In that situation a 15 year loan might be a way of forcing us to payoff the mortgage early, but I wouldn’t want to be trapped in one if a job loss hits. I think having options is extremely important.
.-= kevin´s last blog ..Save for Retirement Now or Payoff Your Mortgage First? =-.

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Jason Unger 2010/03/19 at 8:23 am

Great post – I had never seen the numbers broken down so clearly — and am pretty surprised at the differences.
.-= Jason Unger´s last blog ..Why Bank of America Fired Me =-.

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Monevator 2010/03/19 at 9:21 am

You’ve got to remember that in the days of double digit interest rates, inflation was double digits, too. So your 30 year old long was getting inflated away.

Inflation hasn’t been helping out homeowners in the same way for a decade or more, which has meant faster repayment is more attractive in my eyes.

On the other hand I wouldn’t be surprised at all to see both rates and inflation jump in the next few years.

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Investor Junkie 2010/03/21 at 5:56 pm

My thoughts exactly Monevator. I would rather invest my money elsewhere. Also with a 30 year fixed, I still have the option to pay down quicker if I choose to (assuming no prepayment penalty). Once the money is in your house, it’s harder to take out (though not impossible)
.-= Investor Junkie´s last blog ..Life Isn’t Fair. Now Get Over It. =-.

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Kevin@OutOfYourRut 2010/03/19 at 9:35 am

Jason, Yeah when you see hard numbers you can see why the choice might be a tough one. True, you payoff on the 15 in half the time, but there’s a REAL cost in the meantime. The best you can say for the 15 is that it’s forced savings. That’s a virtue and a sentence at the same time.

Monevator, inflation is a good reason to go longer with the loan term. If you take the 30 year, by year 20 you might be able to pay the remaining mortgage balance in full out of your check book! Having a 5% loan in a 7% inflation environment would be a bonanza you’d never want to pay off.
.-= Kevin@OutOfYourRut´s last blog ..Save for Retirement Now or Payoff Your Mortgage First? =-.

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Big Spender 2010/03/19 at 11:32 am

Nowadays, personal financial management is a cash flow game, because you can’t count on credit to be available for any big ticket purchases. So a 30 year loan makes good sense, recognizing that you can make it a 15 year loan by paying additional principle payments every month.

This gives you the freedom to pay less if you have a job loss, family status change or anything else.

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Kevin@OutOfYourRut 2010/03/19 at 1:56 pm

Big Spender, your comment made me think of something else as well. In the lending environment we’re in, you can’t count on being able to refinance into the loan of your choice any more. So if you take a 15 year loan, find it squeezes your budget too tightly, you may not be able to refinance to a lower payment!

This could happen for any number of reasons, but most commonly, lack of sufficient equity, negative change in financial situation or a change of lender guidelines. Best to opt for the most comfortable fit, taking nothing in the future for granted.
.-= Kevin@OutOfYourRut´s last blog ..Save for Retirement Now or Payoff Your Mortgage First? =-.

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Financial Uproar 2010/03/19 at 2:49 pm

What if we look at three scenarios when it comes to this. Let’s use your example above of the 200k mortgage.

If someone were to take that extra $508 per month and invest it for 15 years at an 8% return? They would have a paid for house, plus a nest egg of over $170k from investing just the difference in payments over the last 15 years of the mortgage.

What if somebody invested the difference (again, $508) every month for 30 years at 8%. They’d end up with over $735k.

And finally, what if someone paid off their mortgage in 15 years and then invested their entire mortgage payment ($1582) for the next 15 years. They’d end up with over $540k.

Clearly the solution is to take the 30 year mortgage and invest the difference between it and the 15 year mortgage every month. Let compound interest do it’s thing. Plus, if times get tough then someone can always omit some savings.

So I agree with you, but not for reasons that you listed.

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JoeTaxpayer 2010/03/19 at 2:55 pm

Clearly? Clearly your assumption of an 8% return over 15 years is flawed. In the 80s and 90s, you were correct, 00s not so much.
It’s all about risk, isn’t it? If one gets the 30 and puts money aside, they can risk it to get a higher yield or take the lower return and hedge the risk of being unemployed. There is no perfect answer.

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Kevin@OutOfYourRut 2010/03/20 at 2:31 pm

Financial Uproar, I’m with Joe on this, and I’ll take it a step further…

If we assume 8% as a long term rate of return, it doesn’t work mathematically against the 10-12% mortgage rates that prevailed in the 80s. It barely works against the 7-9% mortgage rates of the 90s. And an 8% ROI in the 2000s is a non-starter.

What we DO know, here in 2010, is that mortgage rates are at historic lows, which, if we want to use numbers at all, should favor borrowing long at present rates. That’s one of the cool things about a 30 year fixed rate loan–payments will be thoroughly predictable over the term of the loan. If we were in a 10% rate environment, the advice would be to pay off the loan ASAP!

I like what you’re presenting, it’s just that ROI numbers aren’t consistent over long periods of time.
.-= Kevin@OutOfYourRut´s last blog ..OutOfYourRut Friday (but almost Saturday) Personal Finance Round Up =-.

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Evolution of Wealth 2010/03/21 at 9:16 am

I wrote a post about this last September Your Mortgage: When 30 beats 15

Right around 6% was the break even point but there is a lot more issues to this. There’s a big liquidity issue. When your money is invested and you might need it you’re going to have an access problem. 6% isn’t too outrageous over a 30 year period but it’s not a straight line. You go to access some or all of that money and you might be in a period like we are going through right now and that’s going to through a huge wrench in your future.
.-= Evolution of Wealth´s last blog ..What Every Life Insurance Policy Shouldn’t Be Without =-.

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steve 2010/03/21 at 9:53 am

to financial uproar: sorry, but you missed something. Granted you just make $170 K over the 15 years. BUT, for the next 15, you would be investing not $508 but the entire mortgage payment ($1582), as you wouldn’t need to pay a mortgage anymore. Then, you’d be WAY ahead.

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Evolution of Wealth 2010/03/21 at 9:59 am

Steve:
He accounted for this and you wouldn’t be way ahead. Compounding interest takes over on the money invested for the first 15 years and the second 15 years just doesn’t have the time to catch up. Time can be a great friend. I addressed this in my post that I linked to above as well.
.-= Evolution of Wealth´s last blog ..What Every Life Insurance Policy Shouldn’t Be Without =-.

steve 2010/03/21 at 9:39 pm

Sorry, I misstated what I was getting at. Financial Uproar did calculate the last 15 years accurately. BUT, he only did so for the scenario in which someone took out a 30 year loan and paid it off in 15. What I was getting at (or meant to) was that if you take out a 15 year loan at a lower rate, pay it off in 15 years, and during that time invest the difference between the 15 year and 30 year rates, then invest the entire $1500+ for the next 15 years, this scenario makes you the most money.

Steve

Dave Ozment 2010/03/20 at 6:48 pm

This is an interesting discussion. I’m a fan of making all financial decisions with as much information as possible. A 15 year mortgage is great unless the increased payments drive you into bankruptcy.

That said, I think taking advantage of the lower rates today can allow you to compress your time horizon with a managed impact on your payments. Another alternative is to use a raise or bonus to “finance” the switch. Set aside from a surplus the extra dollars required each month with the increased payments

My guess my thesis is “find a way”…. the short term sacrifice is likley worth it.

Good discussion!
Dave
.-= Dave Ozment´s last blog ..Views of Money ““ Part 1: Objective Setting and Simple and Advanced Cash Flow =-.

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RainyDaySaver 2010/03/21 at 9:13 am

While I’m a big proponent of paying off mortgages early, here in NJ, house prices are so high that anything other than a 30-year mortgage likely *would* be financial suicide for many folks who want to own a home. But there’s no reason why you can’t make extra principal payments to help knock down the interest costs and pay off the mortgage sooner. I’d rather pay off the mortgage more quickly than take the risk of investing a lot of that money.
.-= RainyDaySaver´s last blog ..Saturday Link Love: Spring Is in the Air Edition =-.

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steve 2010/03/21 at 9:51 am

Your suggestion is great in this market, assuming the difference between 30 and 15 years is only .5%. By paying off the 30 yr. at the 15 yr rate while you can afford it, you are losing only a little bit in interest. The question is: at what point does the spread in interest rates get to be so high that it’s no longer worth it?

Steve

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JoeTaxpayer 2010/03/21 at 9:03 pm

Steve, I know others have observed differently, but my experience is that spread doesn’t vary so much. You can play with a spreadsheet to see the impact of 30 vs 15 at different rates and spreads. You’ll notice that even at the same rates the difference between 15 and 30 is far less at higher rates that lower. Not intuitive but stands to reason when you ponder it.
.-= JoeTaxpayer´s last blog ..A Spring Has Sprung Roundup =-.

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Financial Uproar 2010/03/21 at 1:25 pm

I’m not sure how mortgage rates from 25 or 15 years ago are really relevant to this discussion. If someone has a mortgage rate in the double digits, then it’s a no-brainer to pay that down as quick as possible. A risk free 12% return obviously trumps 8% in the market. But that’s not the situation now. Wouldn’t someone who locked in at say 9% 15 years ago have long since refinanced by now?

As for the investment part of it, the beauty of investing over long periods of time is that the ups and downs of the market have a way of ending up okay after long periods of time. Oh, and the market has averaged over 8% over the last 100 years, that’s even excluding reinvested dividends. So I’m fairly confident I can get 8% over time. If you look at historical data, the market has had several bad decades.

Investing in the market also gives someone additional diversification so they don’t have their entire net worth tied up in their home. It also gives liquidity.

If you’re so risk adverse that you feel the need to pay off your mortgage in 15 years, then knock yourself out. While I don’t feel it’s the best way to approach it, you’ll hardly be screwed if you do it.

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Budgeting in the Fun Stuff 2010/03/22 at 1:16 pm

We bought our house in 2007 with a 15 year mortgage. We haven’t refinanced our 5.375% rate since we are only 8 years or less from paying it off anyway and the closing costs on a refi would eat up the difference (I’ve checked several times).

The key for us was, like everybody else who commented, we bought a house that we could afford the 15 year payments for…specifically, our house was $114,000 and we put 20% down. Our $91,200 mortgage is about $740 a month. A 30 year would have been about $550 a month, but we knew we could handle the 15 year payments and saved the extra 1% in interest.

We have paid $900 a month ($160 more than necessary) since the first payment and have made additional principal payments as well, so we are on track to pay our home off by the end of 2017.

If we get hit by a financial crisis, we’ll pay for it with our vacation account first, which has about 1.5 months worth of expenses in it. Then we’d start using our emergency fund that has 3-4 months of living expenses in it right now. If it’s worse than that, we also have a few thousand in padding between all our accounts and another 2 months worth of expenses in specific accounts (property taxes for next year, auto and home maintenance money, extra money that goes into our Roth IRA and Scottrade accounts, etc).

Absolute worst case hits, we have three long-term accounts (401k, Roth IRA, and Scottrade) that can be used to add up to another 2 years of expenses. We also have 40% equity in our house already.

I think we’re covered. :-)
.-= Budgeting in the Fun Stuff´s last blog ..Do Your Kids Receive an Allowance? =-.

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Kevin@OutOfYourRut 2010/03/22 at 3:21 pm

Budgeting in the Fun Stuff – Yes, it most certainly looks like you’re covered!

But you brought up another interesting twist on the mortgage debate – the periodic refinance. You’re correct that you’re close enough to payoff that going for a lower rate wouldn’t be justified by the closing costs involved. But the other point so many miss with refinancing is that when you refi you set the payoff clock back to zero!

Say you have a 15 year loan and in year 4 you refi for a lower rate; you’ve just added 4 years to the payoff of the loan, effectively converting your loan from a 15 year to a 19 year. (The alternative would be to take a 10 year loan, but most people shrink away from that when they see the size of the payment.)

Moral of the story is that it isn’t all about interest rates! In fact the deeper you get into your term, the less interest rates matter at all.
.-= Kevin@OutOfYourRut´s last blog ..Making Money-Goes-to-Money Work For You =-.

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Budgeting in the Fun Stuff 2010/03/22 at 5:30 pm

Kevin, you are resetting the clock UNLESS you continue with overpayments. When I looked into refinancing, I looked at 10 year and 15 year rates on the assumption we’d continue to pay $900 a month no matter what. I didn’t care what the payments were since they were under our normal $900 overpayment anyway. That’s a great way to take advantage of lower rates and payoff your home on the same schedule anyway.

Our problem was that we’d save 4 months of payments ($3600) but the closing costs were $4000. So we stayed put.
.-= Budgeting in the Fun Stuff´s last blog ..Do Your Kids Receive an Allowance? =-.

Ryan 2010/03/22 at 5:41 pm

Great conversation here. Personally, I think the 30 year mortgage is a better option for most people because it gives them more long term flexibility, especially if you have the cash flow and discipline to make extra payments. However, a 15 year mortgage can save you more money in the long run. There is a time and place for both mortgages, and I think that as long as you aren’t buying more house than you can afford and are getting a fixed rate loan, then you are being prudent with your money.
.-= Ryan´s last blog ..Highest Paying College Degrees =-.

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Kevin@OutOfYourRut 2010/03/22 at 6:53 pm

The conscensus then, seems to be the 15 year or 30 year are less important than the bigger picture consideration of buying beneath your means. Buy right in the first place and the details will work themselves out.
.-= Kevin@OutOfYourRut´s last blog ..Making Money-Goes-to-Money Work For You =-.

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Rudy 2010/03/23 at 4:22 pm

Kevin, I wish I saw your post 5 years ago when I bought the house with a 15 year mortgage. Having that buffer, in case of emergency, would be a total peace of mind. I had been laid off before and the feeling of not being able to afford the mortgage payment scared me.

Now, I’m considering paying extra towards the principal, pretending it’s a 10 year mortgage. :-)
.-= Rudy´s last blog ..Finding Health and Sanity =-.

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Kevin@OutOfYourRut 2010/03/23 at 4:35 pm

5 years ago? I was in the business back then and might have been able to help!

Actually I was giving out the advice in this post back then and most people were following it. When you present the subject logically, most people understand and agree.
.-= Kevin@OutOfYourRut´s last blog ..Making Money-Goes-to-Money Work For You =-.

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Premium Finance 2010/09/27 at 7:00 pm

god post i think it would be a difficult situation

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ranch111 2011/02/26 at 2:21 pm

We refi’d to a 15-year conventional to a from a 30-year FHA. 6.25% > 3.75% with no change in our overall payment each month. Now, if I want to pretend like we have a 10-year mortgage….

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kevin 2011/02/26 at 6:12 pm

ranch – that was a big enough spread on the rate that it made the move easier. The 10 year would be a dramatic step, the payment would be noticeably higher. The other thing people don’t realize with a 15 year (and more so a 10 yr) is that the tax deduction also disappears more quickly! Not that that should ever hold you back from paying your mortgage in less time, but it is a surprise to a lot of people.

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Golda Moravek 2011/10/28 at 6:42 pm

Keep to see something new from you

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