Consider Fred and Wilma. They are anxious to become the owners of a prestigious house. Naturally, they are both positively bubbling over with excitement. Wilma, in particular, can barely restrain her enthusiasm for the home of her dreams. However, she has the financial brain of the couple and wants to make the best possible choice for mortgage financing. She must choose between a 15 year mortgage at 5% and a 30 year mortgage at 5.5%. In either case, they will borrow $100,000, pay the same in closing costs and neither mortgage note has a prepayment penalty.
A quick analysis of their situation reveals that their monthly payment on the 15 year mortgage (principal and interest only) will be $791. Over the course of the mortgage they will pay $42,343 in interest. Of course, that interest is deductible. Let's assume that Fred and Wilma will be in the 25% tax bracket for the next 30 years. That means, after-tax, the interest costs them $31,757. Their total after tax payments will be $131,756. Interest on debt sure adds up over time doesn't it?
The 30 year mortgage results in monthly payments of $568. Total interest payments will be a whopping $104,404. But, thanks to the deduction Uncle Sam gives them, the after tax-cost of the interest is "only" $78,303 making their total after tax payments equal to $178,303. The 30 year mortgage gives them payments that are lower by $223 but it costs them $46,547 more, after-tax.
One answer would be to take the sure thing, borrow for 15 years and run. But, consider the flexibility of the 30 year mortgage. If they were to invest the $223 per month in common stocks that returned 6%, after tax, for 15 years they would have over $65,177. The balance due on their 30 year mortgage after 15 years is about $69,490. Within the next 8 months, they will actually have more saved than their balance due on their mortgage. The key to this strategy is Fred and Wilma must actually save the $223 each and every month. If they don't, they may have been better off with the "forced savings" imposed by the 15 year mortgage. Investing involves risk and you may incur a profit or a loss. The examples provided are hypothetical and do not suggest or guarantee particular rates of return for any investment. The examples do not include transaction costs and tax considerations that would reduce an investor's return.
How about these three alternative strategies that take advantage of the inherent flexibility of a 30 year mortgage with no prepayment penalty. If Fred and Wilma make 13 payments every year, starting in the first year, the extra $567.79 will reduce their after-tax interest cost to $63,478 and pay off the mortgage about 5 years ahead of schedule.
As an alternative, they might pay the next month's principal along with each payment. For example, with their first payment, they would also pay the $110 in principal that would otherwise have been due on their second payment. Every month they would pay a little more in extra principal. This strategy results in after-tax interest costs of $44,529 and a pay-off in year 18, a little over 13 years ahead of schedule.
A simpler alternative would be to send a flat amount along with each month's mortgage payment. Sending $100 per month would reduce their after-tax interest cost to $51,990 and pay off the mortgage about 8 years early. Each of these alternatives requires discipline. If one does not have the discipline to actually send the mortgage lender the additional funds then the forced savings of the 15 year mortgage might be the best bet.
Of course, this brief article is no substitute for a careful consideration of all of the advantages and disadvantages of this matter in light of your unique personal circumstances. Before implementing any significant tax or financial planning strategy, contact your financial planner, attorney or tax advisor as appropriate.