Monday, January 4, 2010

15 Year Mortgage vs 30 Year Mortgage - Which One Would You Choose?

For more mortgage comparisons, also read:

This is a story about two neighbors with two identical homes, two mortgages and one big financial mistake.


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Mr. A and Mr. B are identical in that they are the same age and they bought identical homes for the same amount of money on the same street in the same neighborhood on the same day. Also, they both have the same amount of financial resources – meaning they both are able to afford to pay the same amount of money.


The only difference between the two men in this example is the type of mortgage that each chose. Mr. A decided to get a traditional 30 year mortgage with a fixed 6% rate of interest with a payment of principle and interest of around $1800.00 per month.


Mr. B decided to pay his mortgage off early and got a 15 year mortgage with a fixed 5 and a quarter percent rate of interest (a little lower than Mr. A’s at three quarters of a percent lower) with a payment of principle and interest of about $2,400.00 per month (a bit higher than Mr. A’s - $612.98 higher to be exact!)


Which mortgage would you choose at this point?


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Another difference to be noted is that because Mr. A will be paying for a longer term than Mr. B, he will also be paying more interest than Mr. B. Mr. A will have to pay almost $350,000.00 above and beyond the original cost of the house for the interest during the term of his mortgage, while Mr. B will only have to pay around $134,000.00 in interest during the term of his mortgage.


So, to recap: Mr. A will save $612.98 a month on principle and interest, as compared to Mr. B. Whereas, Mr. B will have a three quarters percent lower interest rate; will have his home paid off 15 years earlier and will save over $213,000.00 on interest payments, as compared to Mr. A.


Now which mortgage would you choose?


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Now, at the 15 year mark, Mr. B has his mortgage paid off. But if you look at Mr. A, you can see that at 15 years, he still owes a little over $213,000.00!


Also, Mr. B has been so used to paying around $2,400.00 per month for his mortgage; he decides that, since he is able to, he will continue paying that amount per month for the next 15 years … but as an investment into a mutual fund. With the mutual fund’s return on investment working at 10%, which is pretty conservative over a fifteen year period, that would pump out a little over $1,000,000.00!!


So, here are the facts so far: Mr. B will have three quarters of a percent lower interest rate; will have his home paid off 15 years earlier and will save over $213,000.00 on interest payments, as compared to Mr. A. Also, Mr. B will have accumulated a little over $1,000,000.00 by the end of the 30 year period.


The 15 year mortgage is looking pretty good, isn’t it? Can it get any better than this?


The truth is it can get better than this. What Mr. B did was very good, but it was not the best.


Sometimes "The good is the enemy of the best."


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Now, for the rest of the story: In the beginning of this example, it was mentioned that both Mr. A and Mr. B had the same financial resources, so Mr. A could have decided to make the higher monthly payment and pay his house off in 15 years.


However, Mr. A decided to invest the extra $612.98 per month (the difference between Mr. A’s monthly payment and Mr. B’s monthly payment) into two Roth IRAs (one for himself and one for his wife). If his investment was working at 10% for 30 years Mr. A would accumulate almost $1.4 million that would be totally tax free!


An interesting fact is that most of Mr. B’s $1,000,000.00 would be taxed upon withdrawal because most of it would not be able to be placed into a Roth IRA.


So, in this example, both neighbors invested the same amount each month for 30 years; however, because Mr. A understood the Time-Value-of-Money – he ended up at the end of 30 years, with an additional almost $390,000.00 of Tax-Free money.


Another nugget:


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You might still be saying to yourself that at year 15, Mr. B now can sleep easily knowing that he has his house fully paid off and has no debt, while Mr. A still owes around $213,000.00 on his mortgage.


That is true, however, here's an interesting note: by investing the difference in the two mortgage payments each month, Mr. A would have accumulated enough in his mutual fund, after 15 years, to completely pay off his remaining mortgage, and still have an additional $43,000.00 left assuming a 10% Return on Investment. If Mr. A had been investing the difference (the $612.98) per month for 15 years; at 10% Return on Investment he would have accumulated a little over $256,000.00 which would more than pay off the mortgage, and he would still have some left over in his investment. Even at 8% Return on investment, he would have accumulated a little over $213,000.00, which would still be enough to pay the rest of the mortgage.


As was mentioned earlier, with Mr. A's investment working at 10% he ended up after the 30 years with an additional almost $390,000.00 of Tax-Free money as compared to Mr. B. However, let's suppose the investment was working a little bit harder, say at 12%. The 30 year difference at 12% return on investment would equal almost $950,000.00 of tax free money!


Furthermore, if money ever got tight during the first 15 years, Mr. A could always decide to pay up to $612.98 less per month, whereas Mr. B would be locked in at the full $2411.63.


So, now you can see that taking the 15 year mortgage over the 30 year mortgage can become a very costly financial illusion.


The moral of this story is that when dealing with mortgages, always try to choose the term that is the longest, the interest rate that is the lowest and, most importantly, to invest the rest!


I'm so excited to share this information with you. If you have enjoyed the information or feel that it would benefit someone else, please share it. If you have any questions or comments, please feel free to contact me.
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