[Editor's Note: The following guest post was submitted by reader Chris Davin, an aerospace engineer at NASA Jet Propulsion Lab (The opinions and viewpoints expressed in this article are the author's and not NASA JPL) and the spouse of an EM physician. While looking for a house to buy in Southern California, he began to carefully consider the issue of choosing a 15 vs 30-year mortgage. After a lot of research, he decided to write a guest post and share his findings with our community. We have no financial relationship.]
In this article, I recommend that a 30-year fixed-rate mortgage is best for most people. I realize this may be controversial among the finance blog/FIRE community, but I think I have a solid case to make. I have come up with four criteria that a home-buyer should consider when choosing between a 15 vs 30-year mortgage, and readers of this blog will disproportionally meet them, but some won’t. In any case, this post is targeted at the typical high-income professional working a normal-length career, not a FIRE hobbyist saving 60% of her gross income and wanting to retire by 45.
The key advantage of a 30-year mortgage is the lower monthly payments. For example, consider the purchase of a $1M house with 20% down and an $800,000 mortgage. For a 30 year mortgage with a 4.0% interest rate, the monthly principal and interest (P&I) payment would be $3,819. The main reason to consider a 15-year note over a 30 year is that the interest rate is typically lower. At today’s rates, the difference is about 0.25%. For a 15 year mortgage at 3.75%, where the monthly P&I would be $5,817; it means a difference of $1,998. For most people, the advantage of a lower payment outweighs the lower interest rate.
4 Criteria for Deciding Between a 15 or 30 Year Mortgage
#1 The Payment
For those buying an inexpensive house relative to their income, the higher payments for the 15-year note are less of a burden, so the lower interest rate might be worth it. Here in Southern California, where home prices and taxes are both high, and physician incomes are low, this is a rare situation. Between the coastal states, it’s much more common.
Keep Debt to Income Ratio Less Than 30%
Banks considering you for a mortgage typically look at your “debt-to-income ratio” (DTI), which is the ratio of your monthly payment on the mortgage (including principal, interest, property tax, and insurance), plus any monthly payments on other debt you may have (car loans, credit cards, etc.), divided by your gross monthly income. Most banks will not write you a mortgage with a DTI of more than 43%, but just because a bank will lend you that much money doesn’t mean it’s a good idea for you.
Even in a high cost-of-living area, I would recommend keeping your DTI less than about 30%. More than that, and you lose too much financial flexibility by having to make those huge fixed monthly payments. But if you can get a 15-year note on your house purchase with a DTI of less than 30%, it might be worth considering.
#2 Contributing to Tax-Advantaged Accounts
Can You Make the Payment AND Max Out Retirement Accounts?
The tax savings of contributing to tax-advantaged accounts is too good to pass up for a 0.25% savings on a mortgage rate. If, however, you can comfortably make the payments on the 15-year note AND make the maximum contributions to all your available tax-advantaged accounts, then the 15-year note might be worth considering.
The contribution limits on tax-advantaged accounts might be higher than you think. If you and your spouse are at least 50 years old and your spouse works too, you could have easy access to $108,000 of annual contributions to tax-advantaged accounts: $56,000 plus $6,000 catch-up to your individual 401k, $19,000 plus $6,000 catch-up to your spouse’s 401k, $6,000 plus $1,000 catch-up Backdoor Roth IRA contributions for each of you, and $7,000 for the family Health Savings Account. Even if your age doesn’t allow you to make catch-up contributions now, you still need to account for them if you or your spouse will turn 50 during the term of the loan.
You might have access to more or less than this amount. Make sure you are able to comfortably contribute the annual maximum to all your available retirement accounts, as well as your other savings goals (eg. education), with some positive cash flow left over, before choosing a 15-year mortgage.
#3 Investing vs Paying off Debt
A fundamental issue at the heart of the 15 vs. 30-year mortgage question is whether the money saved with the smaller payments can earn a better return elsewhere. Mathematically, the “return” of paying down debt is equal to the after-tax interest rate. This can be compared to the after-tax rate of the return from various investments.
Risk Tolerance
Chris Davin
Historically, stocks have returned about 10% per year and bonds have returned about 5%, although current yields on investment-grade bonds are closer to 4%. For a younger investor with decades to grow a nest egg and some tolerance for taking risk, a portfolio tilted toward stocks (say, 80% stocks and 20% bonds) is usually recommended by financial planners. It wouldn’t make sense for such an investor to earn an 8% return (after-tax if the investments are inside a tax-advantaged account) and simultaneously pay down a 3.75% mortgage (about 2.5% after-tax, if interest is tax-deductible) on an accelerated schedule. After 15 years, the $1,998 per month payment difference invested to earn 8% will exceed the remaining balance on the 30-year mortgage with lots of money left over.
Even under the worst conditions, if mortgage interest is not tax-deductible, investing in a taxable account, and with California tax rates, you would only need to earn a 5.7% annual return on a side investment to outperform the interest rate difference between the 15 and 30-year notes. Over a time period more than a decade, this return should be achievable with reasonable investments. If you’ve already decided you can handle the volatility and risk of more aggressive investments, you might as well take advantage of the higher returns with the smaller payments on the 30-year note.
On the other hand, with a conservative portfolio returning closer to 5% with still some risk, it makes a lot more sense to take the guaranteed “return” of around 2.5-4% by paying off the mortgage faster with a 15-year note, especially if mortgage interest is not tax-deductible.
#4 Income
Finally, anyone considering a 15-year mortgage should have a very stable income. If family income drops or is eliminated for some time, the lower payments on the 30-year note will make it easier to bridge that gap without defaulting. Fortunately, the majority of those reading this post (physicians) likely have unusually stable jobs already. If you have a spouse who works in another field and contributes to your household income, you need to consider their job stability as well.
Who is a 15-Year Mortgage Right For?
In summary, if you are buying an inexpensive house relative your income, can easily fully contribute to your tax-advantaged accounts, prefer conservative investments, and have an especially stable job, a 15-year mortgage is probably the right choice. Everyone else should get a 30-year mortgage, at least until the current interest rate environment changes.
- Payments on the 15-year note will not be a burdensome percentage of your income.
- You are able to maximally contribute to all of your available tax-advantaged accounts (401k, IRAs for self and spouse, HSA, etc.) while making payments on the 15-year note.
- You tend to invest in conservative lower-return assets (like bonds) much more than riskier higher-return assets (like stocks).
- Your income is very stable.
Other Factors Affecting Your Decision
Inflation
Another advantage of the 30-year mortgage, although harder to quantify, is that it provides more protection against inflation. In the case of high inflation, those fixed monthly payments will become easier and easier to make.
Liquidity
Along with this protection comes a higher level of liquidity by having (presumably) larger liquid savings. If your situation changes, it’s easy to decide to pay off the mortgage faster, or completely. But, if you need to go the other direction later and liquidate some of your home equity, it will almost certainly be at a higher interest rate than a mortgage you can get today.
I know many readers of this blog are debt-averse, and I understand why, but there are some real advantages to carrying debt on as good terms (long term, low interest, tax-deductible, no call risk) as a 30-year mortgage.
Pay off Strategies
Some Bogleheads and bloggers recommend taking a 30-year mortgage but paying off on a 15-year schedule. Of course, this strategy loses the benefit of the lower interest rate, but it does pay off the loan just as fast while giving the flexibility to drop to a smaller payment if your cash flow situation requires it. Personally, I don’t like this strategy.
On the example loan I gave above, it costs $100 extra per month to pay the higher interest of the 30-year mortgage on a 15-year payoff schedule, and this difference might or might not be tax-deductible. If I had the means and were committed to paying off the mortgage in 15 years, I would want the benefit of the lower interest rate. Put another way, would I buy an insurance policy from the mortgage company with a $100/month premium that let me decrease my payments by about one third any time I wanted? Probably not. But if you decide it’s worth the money to you, go ahead.
Forced Savings
One argument in favor of the 15-year mortgage I don’t accept is that the higher payments represent “forced savings” by building home equity, and this is better than spending the difference in payments on frivolous things. This point is where the behavioral and mathematical aspects of personal finance intersect.
It’s definitely true that a 15-year mortgage is a better option than a 30-year mortgage if the monthly difference is wasted by meaningless spending. However, if you or your spouse have a behavioral finance issue, you really need to fix that issue before buying a very expensive house and the decades of large payments that come along with it. Once the behavioral issues are fixed, then you will be in a position to make the mathematically best choice. In any case, most savings and investment accounts can be set up with automatic contributions anyway, so the temptation to spend money in the checking account can be just as easily removed this way as with a 15-year mortgage.
What do you think? Did you choose a 15 or 30-year mortgage when you bought a home? Do you agree with the recommendations of the author that most should choose a 30-year mortgage? Why or why not? Comment below!
What is missed is the exponential curve..If you believe in the long term “compounding” of equities… a 30 year gives you more money to invest for a longer time period. On a 30 year curve most of the growth happens in the last 5-10 years. If you aggressive pay off debt first you lose the good part of the curve on the back end.
Great post.
Was hoping to get some folks’ thoughts on refinancing from 30-year fixed to 15-year fixed on a studio condo.
Currently owner-occupant but intend to transition it into an investment property within the next 5 years.
Original loan 3/2018: 340k @ 4.375% 30-year fixed
I decided to lower the principal to $300k (after funding my 403b, 457b, and backdoor Roth for the year)
@ current 30-year fixed 4.375%,: $1698/mo P&I
refinance to 15-year fixed 3.625%: $2163/mo P&I
Is it worth the higher up-front payment of 15-year fixed if it’s going to become an investment property rather than my forever home?
I understand that paying it off faster will increase cash flow from investment property in the future VS I would invest the $465/mo difference into SP500 index fund.
OR maybe I stay put for now and if a recession does hit in the next 18-24mo, can refinance then at even better rate?
Thank you
s
Going to a 15 year will shorten the time until it REALLY has good cash flow, but will hurt your cash flow until it is paid off and may decrease your returns by decreasing how much leverage you use.
It really comes down to your goals- do you want to improve cash flow and investment return at the risk of higher leverage, or do you really want to minimize your leverage risk and be debt free. There are pluses and minuses to both.
Thank you!
It seems like you’re leaving out the most important number in the scenario: total cost of financing.
$300K @ 4.375% for 30 years => $539,228
$300K @ 3.625% for 15 years => $389,360
If you can carry the higher payments, why would you want to pay an additional $150K in interest? It’s deductible as an investment property (when converted), but still money out the door to someone else. Since you were able to pay down $40K along with funding several retirement accounts, it doesn’t sound like the additional $500 / month would even be noticeable.
I went through a similar scenario about two years ago and decided on the 15 year mortgage. The idea of a completely paid off investment property is very appealing. I’ve come to think of leverage in real estate along the same lines as taking portfolio loans. It’s more a tactic for people getting started that real estate gurus enjoy using for pitching their info products “Learn how to use the Bank’s Money to become RICH!!!”
Unless you’re going to be an active real estate investor with a portfolio of properties that requires ongoing cashflow management, those extra years of “bonus” rental income go a long way toward FIRE. You’d have an additional $300K of rental income during Years 16 – 30 instead of sending it to the bank.
Sorry, but I disagree that total cost of financing is the most important number. If you’re trying to boil a decision down to one number, then it should be Net Present Value calculated with a reasonable discount rate (eg. 0-1% real). Internal Rate of Return is also a good metric, and closely related to NPV. If you don’t have any higher return investments available than your mortgage, then yes, paying down a mortgage will give you the highest return. But given that after-tax mortgage interest rates are on par with historical inflation, and much less than historical returns of certain asset classes, I think a reasonable argument for some leveraging can be made.
Thank you! Appreciate your thoughts.
Then you are ignoring the additional cash flow the 30 year would allow for and what could be done with those funds.
Not ignoring it, just not running out the numbers since paying off the debt quicker is almost universally better.
Try to come up with an investment scenario where an extra $500 / month for 15 years turns out better than an extra $1,250 / month down the road plus a fully paid off asset worth $500K+. That’s the financial basis.
The real world basis is I’ve met ZERO people (investors or not) who have ever reliably invested the extra cashflow without touching it. Those people are the unicorns of personal finance. And as usual, the risk of carrying a 30 year note is much higher than a 15 year note. A simple fact that’s always conveniently ignored in these arbitrage arguments.
I think you’re overstating the case with “almost universally better.” It’s easy to come up with an investment scenario such as you describe. It’s basic math. If the investment return is more than the cost of the leverage, you come out ahead. That’s basic leverage.
Not saying whether it is a good idea or not, but if you think it’s insane you probably aren’t running the numbers correctly.
To evaluate these scenarios does one always have to assume that one will be staying in the home at least 15 years?
No.
The investment calculator spits out $199,222 for investing $500 / month for 15 years @ 10.00%.
That’s a pretty darn good rate and still leaves you well below the property value appreciation alone.
What kind of returns do you think are possible?!?
You must be making a math error to reach the conclusions you’re reaching.
Let’s run the numbers here. We’ll assume 8% returns on the side investments, a 3.5% 15 year mortgage and a 4% 30 year mortgage on a $500K mortgage. Appreciation of the house is irrelevant since it is equal under both scenarios. So we’ll consider only the cost of financing and the opportunity cost.
Annual payment on a 15 year mortgage is $43,413 (=PMT(3.5%,15,-500000,0))
Annual payment on a 30 year mortgage is $28,915 (=PMT(4%,30,-500000,0)
The difference is $14,497.
$14,495 at 8% for 15 years = $393,624
After 15 years, the person with the 30 year mortgage still owes $322,717
The 30 year mortgage person (who managed to make 8% with the difference) comes out $70,911 ($393,624-70,911) ahead. Yes, there is some adjusting for taxes, but that likely occurs on both ends and more or less equals out.
Now I didn’t adjust for risk or anything, but to deny that you don’t come out ahead mathematically by borrowing at 4% and earning at 8% is simply wrong.