15 Year Mortgage or the 30 Year Mortgage?

(February 2nd, 2008)

This is in response to a superb article written by Dan Green @ www.themortgagereports.com. The article is located here.

Yes it is true that most people want to fully pay off their homes, so that they do not have to worry about the mortgage payment each month. Most people also realize that if you select the 30 year mortgage, you will be paying a heck of a lot of interest, adding up to $200,000 - $500,000 depending on the size of your mortgage loan. And who blames them? Heck, I would love to pay off my home in as little as 5 years and save all the money I would pay in interest, but that is hard to do!

Thus, in order to accomplish their goals, people set aside a few hundred or a few thousand dollars each month and put this money towards the original principal balance of their mortgages. I will use a real life example to illustrate the points I am trying to make, which are congruent to that of Dan Green from the Mortgage Reports.com Also note that I will be using a real life number of $285,000 rather than a standard "$100,000" number, which is always hypothetical and not real life.

Coree has a $285,000, 15 year fixed-term mortgage loan and is paying current market interest rate of 6.2%. Using our Simple Mortgage Loan Amortization calculator, here are the numbers:

Now lets consider a different scenario where Coree amortizes her $285,000 mortgage loan over a 30 year term with the same 6.2% interest. Here are the numbers:

Right off the bat, you will figure Coree is paying too much interest in the 30 year term, a whopping $189,931.99 ($343,393.17 - $153,461.18).

But if we take this number $189,931.99 and calculate the mortgage interest tax deductions that Coree can make, the cost-benefit analysis will make more sense. Imagine Coree is in the 28% tax bracket.

If she pays $189,931.99 more in interest over the 30 year term, she will have a mortgage interest tax rebate of $53,180.95 more than she would if she had chosen the 15 year mortgage. Here is how we derive that number.

This means over the 30 year term, Coree will have $53,180.95 MORE cash sitting in the bank, gaining compound interest and increasing over time. Furthermore, Coree will have an additional monthly cash savings of:

Now lets use a compound interest calculator shall we? Here are the numbers:

Do you see how Coree would have a whopping $681,181.18 sitting in her Savings account after 30 years, if she follows this compound interest model? First, the annual addition of $8248.32 comes from Coree's monthly savings of $690.36 times 12 months. I chose a conservative interest rate of 4.2% because most banks would offer that kind of an interest rate. I also set the current principal to $53,180.95 (remember this number is derived from the mortgage interest tax rebate that Coree would receive over the 30 years). I do not want to complicate these calculations further, thus I simply set the current principal to $53,180.95

I think Dan would definitely agree with me on all these points I have made. In America, we have the priviledge of deducting the interest we pay on our mortgages against our income, and reduce our "taxable income." This gives us more cash in the pocket. If Coree had chosen the 15 year mortgage, yes she would definitely have saved herself a lot of interest payments. But then, she would not have the $691,181.18 at the end of the 30 year period in her savings. Also because her monthly payments are so high $2435.90, she would be cash strapped. Much like how writers call those people "House rich and Cash Poor."

Please feel free to post comments to this article. If you have other ideas or strategies for mortgage tax deductions, interest rate savings or other theories and ideas on how to go about the mortgage process, you better post!

Comments

Mike Comments on February 20th, 2008

Hi again -

You also make some good points. You're right that saving that much a month is rather extreme (although she probably does earn more than $5,000 a month/$60,000 a year to be in a 28% tax bracket). I'm lucky to live in a town where rent is $350 a month and houses cost $50,000 and completely overlooked the fact that living expenses are a constant -- as you pointed out, during the years she was saving, there would be expenses such as rent that would not occur if she was a home owner. Then again, she will likely encounter expenses as a home owner that a renter wouldn't see (such as property taxes and home repairs). It usually ends up being cheaper if she can save and purchase a home using cash, but there is an invaluable convenience factor to being able to purchase a house now instead of later (that's the whole basis of credit). Some people also point out that if you have the cash handy, it's still sometimes advisable to take out a mortgage because you may be able to earn better returns on the cash if you invest it than what what you'd pay in interest. This is a risky strategy however, and at most you should only hope to break even doing it.

I would point out that a tax deduction is not the same as a tax rebate (or tax credit), and mortgage interest is claimed as a deduction. Yes, the full deduction would be $189,932 (spread out over 30 years of tax filing), but as a deduction, not as a credit. To point this out best, let's assume a home owner lost their job after taking out a mortgage and had no income for one tax year. If mortgage interest were a rebate, they would still receive a check from the government for a certain percentage of the interest paid. However, this is not the case. It is a deduction, meaning it lowers one's taxable income base. So if you earned $0 a year and spent $10,000 in interest, you would owe the government $0 in taxes with or without the interest paid, and would not receive any rebate check (in other words, you're stuck paying the interest in full with no benefit). Earning $0 may sound absurd, but some people take out 30 year mortgages in their middle years, and by the time they reach the end of the mortgage, their retirement income may not be enough to maximize the benefit of mortgage interest deduction. (Some retired people only have interest income to claim, such as those who take a "lump sum" retirement)

This brings up another overlooked fact in mortgage interest deductions... interest payments are paid most heavily at the beginning of a mortgage (an amortization schedule shows that typically the first few years' payments are 80+% interest). Typically, young people take out mortgages. Since the heaviest interest payments are made in their younger years, the benefit is reduced somewhat because people typically earn less in their younger years (say, a 15% tax bracket) and are paid more as they progress through a career (say to a 28% tax bracket). So instead of getting "28 cents back" for every dollar paid in interest, you may only get 15 cents during the years when you're paying off most of the interest. Also, tax deductions are much more appealing to people at higher incomes because they can bring them into a lower tax bracket, which affects the amount of tax they pay on their total income.

The difference between a deduction and a rebate important because there are tax rebates (credits) out there. One good example was the telephone excise tax rebate from 2006. I believe it was a $40 credit, which means if you only owed the government $30 in taxes, the rebate still applies in full and you would receive a check for $10. It doesn't matter if you earned $80,000 a year or $5,000 a year, you still received the same $40 credit if you qualified. The fundamental difference: is the government actually giving me something (credit), or are they simply requiring me to pay them less (deduction)?

Hope this was a good read and feel free to post it if you'd like -- please write me back with any points you have!
Mike

Abdulrasool Comments on February 15th, 2008

Hello Mike,

Thanks for the wonderful post.

The $53,000 is a tax rebate because "if she pays $189,931.99 more in interest over the 30 year term, she will have a mortgage interest tax rebate of $53,180.95"

28% x $189,931.99 = $53,180.95

The full deduction is $189,931.99 isn't it? Correct me on this if I'm wrong.

Your other points about spending the 100% deductible interest to get a 28% tax rebate is correct and I missed that. And yes I placed the $53,180.95 as "Current Principal" in the compound interest calculator because I wanted to make the calculations a bit easier - but that was completely flawed and you are correct!

Your suggestion of chopping it in half, compounding it and then adding the other half many years later is probably a little more conservative.

I also like your comment "Then for the next 27 years, she can pay the would-be $1,700 mortgage payment to herself, which would accumulate to an additional $700,000 after compounding."

If she makes $8000 a month (which is probably not the case, more like $5000), after paying her rent, groceries and all other expenses, she probably won't save more than $3000 a month, which is about $36,000 a year. Therefore it will take her about 8 years to come up with the full $285,000 ($285,000 / $36,000 = 8 years). You're also forgetting the fact that for those 8 years of saving for equity, she will be paying rent, say $1200 a month x 12 months x 8 years = $115,200.

I would rather pay the $115,200 in mortgage interest, and then deduct it from my income than paying my landlord $115,200 in cash and getting nothing from it, but that's just my thoughts.

Thanks for your premium comments, I hope you can participate more on this website.

Best of luck,

Abdulrasool Sumar

Mike Comments on February 14th, 2008

Hello - Good article, however I see this common flaw in logic quite frequently (I work for a bank). You stated that, by taking a 30 year mortgage over a 15 year, Coree would get a $53 grand tax "rebate," which she could save and make compound interest off of. However, may I point out that it's a deduction, not a rebate. She doesn't get cash from the government (to put in a savings account), but rather she is required to pay less in taxes. Furthermore, she has to "spend" the deductable interest (100%), to get a 28% break on that amount. It's like spending a dollar to pay 30 cents less in taxes. And lastly, she doesn't get the $53 grand in tax savings all at once, so placing it at the current principal and then trying to compound it over 30 years is flawed. Chopping it in half and compounding it, then adding the other half, would be more realistic. And getting 4.2% on a savings account will get more and more difficult as the Fed drops its rates.

My theory - if she is in an effective 28% tax bracket, she's earning very good money - probably $8,000 a month or more. By trippling what would be her 30-year mortgage payment and paying it to herself instead (saving $5236/mo), she would be able to buy the house cash in less than 4 years and save $343,393 in interest, not to mention closing costs and the frustration of applying for a loan. Sure, there's no "tax break," but she doesn't have to spend the dollar to save the 30 cents (that's a 70% better option). If triple is too much of a budget crunch, even double would yield similar results.

Why less than 4 years when it would take 4.5 to save the principal at that savings rate? Because instead of paying interest to a bank, she would be earning compound interest as her savings grew (and paying 28% tax on it). Well invested, she might only be looking at 2 or 3 years of intense saving. Plus she gets full equity in the home immediately and no one can foreclose on it, ever. Then for the next 27 years, she can pay the would-be $1,700 mortgage payment to herself, which would accumulate to an additional $700,000 after compounding. Between the savings from not paying loan interest and the "would have spent otherwise" saving, she could easily increase her cash assets by one million dollars and have a $285,000 home (which appreciates) paid in full. Not too shabby.