If you are getting ready to buy a home, you have to consider a 30 vs. 15-year mortgage. (For now, we’ll exclude the Balloon Payment Mortgage and just compare these two.) But which are the best loans for first-time homebuyers?
The following is a guest post by Doug Warshauer. He is the founder of Kessler Warshauer Ventures, a private equity investment firm. He writes on personal finance and lifetime financial management. His book If I’m So Smart…Where Did All My Money Go?: Balancing Your Financial Objectives for Lasting Wealth will be released this summer.
You are getting ready to buy a home. Your first home. Among the many important decisions to make, you must decide whether to choose a 15-year or a 30-year mortgage. (Read “How A Mortgage Works.”) Information on this question is easy to find: if you search around a bit, you can find a number of articles that compare 15-year and 30-year mortgages, suggest the pros and cons of each and can help you think intelligently about which one might suit you best.
I have not, however, found one that deals specifically with the question of whether a 15-year or a 30-year mortgage is best suited for someone buying their first home. First-time homebuyers have unique circumstances. Most importantly, they usually expect to live in their home only 5-10 years, upgrading when they need more space and can afford a more expensive home. Taking this into account leads to some surprising conclusions.
A numerical example helps shed some light on this decision. Here are a few assumptions for this example:
You have savings of at least $60,000 that you could, if you choose, devote to a down payment on a home, and you intend to put 20% down on your home.
You have decided that you can afford mortgage payments of up to $15,000 per year.
You can obtain a 30-year mortgage at an interest rate of 5.0% or a 15-year mortgage at an interest rate of 4.5%.
Given those assumptions, here are two alternatives. Each alternative results in your making mortgage payments of roughly $1,250 per month:
30-Year Mortgage: Buy a home for $291,000, putting $58,000 down and taking a 30-year, $233,000 mortgage.
15-Year Mortgage: Buy a home for $204,000, putting $41,000 down and taking a 15-year, $163,000 mortgage. (If you go with this option, you are able to keep an additional $17,000 in your savings account.)
Which option is better?
The 30-year mortgage has a big advantage: you can buy a much more expensive home, almost 50% more expensive. So when you ask, “How much can I afford for a house?” the answer is a function of which loan you take.
Keep in mind that you are making equivalent mortgage payments with both options, so, at least while you are living in this home, you are not sacrificing your ability to spend in other areas or contribute to your savings goals.
In fact, while you are living in your home, you are actually benefiting from a larger tax deduction from the 30-year mortgage, even though the mortgage payment is the same, because a higher proportion of the payments are categorized as interest payments.
So, if the 15-year mortgage is going to be preferable to the 30-year mortgage, it would need to have some substantial long-term benefits. These benefits should show up when you upgrade to your next home.
If the 30-year is better in the short term, which is better in the long term?
Suppose you decide in to upgrade in five years. When we do the math, it turns out that it isn’t completely predictable which option puts you in a better position when you upgrade. Here are the three variables that matter:
The growth in home values over that five year period. The higher the growth rate, the better the 30-year does. Why? With a higher home value, the same growth rate produces greater absolute dollar growth. 10 percent growth increases the 30-year’s home value by $29,100 and the 15-year’s home value by $20,400, a difference of $8,700. 20 percent growth increases the 30-year’s home value by $58,200 and the 15-year’s by $40,800, a difference of $17,400. But is now the right time to buy a house since values are declining? In such an environment, the 30-year mortgage is less attractive to say the least.
Your tax rate is another factor. The higher your tax rate, the better the 30-year does. Why? More of its payments are interest payments, which are tax deductible. The higher your tax rate, the more tax deductions help you. For someone in the 25% tax bracket, the difference is close to $1,000 per year in tax savings.
Your investment growth on the money not spent on the down payment is another factor in the 15-year option. The higher the rate of investment growth, the better the 15-year does. One caution: don’t assume equity returns on that investment. Five years is not enough time to invest in stocks. I think the fairest assumption is that you are able to invest the saved down payment at the same rate of return that your home values grow.
In most circumstances, the 15-year does leave you with more equity to roll into your new home. It takes a housing growth rate around 7% – far in excess of historical norms – for the 30-year to win. If home values grow at a more typical 3.5% rate, the 15-year will leave you with about $15,000 more to spend on your home upgrade.
If we run the numbers again for a home upgrade in 10 years instead of five, the results don’t change materially. It still takes an unusually high 6% growth rate for the 30-year to break even. At the 3.5% rate, the 15-year wins by close to $25,000.
Is living in a more expensive first home worth reducing the amount of equity you will have to roll into your next home?
Here’s one way to decide: compare the amount you sacrifice in the future to the difference in the rental value of the two homes. The above calculations suggest that you sacrifice about $2,000 – $3,000 of second home value for each year you live in your first home. Compare this to the difference in rental value of the homes. Using the historical average rental rate of 5%, the $291,000 home would rent for about $14,500 per year, and the $204,000 home would rent for $10,200 per year.
The difference, $4,300 per year, is greater than the amount that choosing the 30-year is likely to cost you. On that basis, at least, it appears that the 30-year gives you a good deal for your money: you live in a better first home without having to spend a whole lot more order to live there.
But shouldn’t we defer present gratification for our future benefit?
Every rule has its exception. Consider this: moving multiple times over the course of your life reduces your net worth. The transaction costs involved in buying and selling a home (broker fees, legal fees, title fees, transfer taxes, moving costs, etc.) typically drain away 10% of the value of your home. The more times you move, the more times you subtract this amount from your total net worth.
Choosing a 30-year mortgage may help you limit your number of moves because you’ll be more willing to remain in your first home longer. As your family grows or your children get older, the larger space is more likely to meet your needs. If choosing a 30-year increases the likelihood that you will only move once, it actually may increase present gratification AND provide future benefit.
Do you find this conclusion surprising? I confess that this is not the outcome I expected to reach when I began considering this question. The 15-year mortgage represents many of the characteristics that are normally beneficial in managing your finances: a lower interest rate, reduced consumption and automatic savings. Despite all those advantages, for most people it is the wrong choice for a first home. The traditional 30-year mortgage makes more sense.
Scott McKeen, MBA says
Interesting analysis. Having been on the front lines of the mortgage industry as a mortgage banker and having lived through the highs and lows of the real estate bubble, I think a better analysis would be rent vs. buy. For such a short time horizon, buying doesn’t really make sense – and I think I could make a case that buying almost never makes sense! Most analyses that I have seen ignore the total costs of ownership. Also, I don’t hold to the idea of buying a home for a personal residence as being an investment (investment property on the other hand is). If someone wanted to shorten the 30-year mortgage without refinancing, they could simply make additional principal payments each year. If you look at the entire time horizon of the commitment, there is no doubt that you will pay several times over with a 30-year mortgage. Lastly, never make a decision based on tax benefits alone. Tax benefits only make a sound decision better.
Neal Frankle says
@Scott, I agree that the “rent vs buy” is an important topic – but a very different one. I also agree that tax benefits only make a sound decision better. I do not think this post makes the argument solely on tax benefits.
Being a homeowner, I realize that what you are saying makes sense. The cost of ownership is far higher than simply the mortgage, tax and insurance. I have also arguments trying to make the case that buying never makes sense. These arguments do make good points but……
a. Most rich people became rich by owning real estate.
b. In my practice, the people who own real estate are far wealthier than those who rent.
c. This is very region specific.
A government study came out recently (reported by the IBD) that it is cheaper to own than rent in 85% of the cities in the USA. I do not know if this study included ALL the costs of ownership.But I do know that owning a house in S. Florida for example is a far better move than owning one in Los Angeles – when you consider the alternative of renting.
We are refinancing a 6.25% 30-year FHA loan to a 3.75% 15-year conventional. Getting rid of the PMI. Taking control of the ripoff escrow. Our P&I went up about $65. I think we can handle it.
Sara A. says
If you can’t afford a 15 year mortgage, you can’t afford the home!
Belmont Thornton says
I feel the sooner you are out of debt the better. If the repayment period is short then the amount is high, but if you see the better side of it, you are getting out of the debt sooner.
Financial Bondage says
15 year loan saves money. I would get no longer than a 20 year loan.
shorter loan means your payment is higher but you save money in the long run.
Ok you got me –
30 yr $291K home
15 yr $204K home (plus the $17K)
What about getting the smaller home, investing the $17K, and also invest the difference by taking the 30 year mortgage? Moving and the buy/sell friction certainly costs, but far less than living in the 2000sq ft house long enough to know if you really need that McMansion.
Doug Warshauer says
I think that’s a great point. If you can be satisfied with the smaller home, you are still better off with the 30 year mortgage. Your $163,000 mortgage mortgage would have payments of about $875/month instead of $1,250/month, leaving you an extra $375/month to save or spend as you see fit.