Financial

A 15-Year Mortgage Is Probably Best, But It Has One Big Disadvantage

Out of all the mortgages out there, a 15-year mortgage will likely save you the most amount of interest. 15-year mortgage rates are almost always lower than 30-year fixed mortgage rates. Further, because the mortgage fully amortizes across a 15-year duration, you will likely pay off your mortgage sooner than if you had a 30-year amortizing mortgage.

Ever since I purchased my first property in San Francisco in 2003, I’ve actually preferred adjustable rate mortgages (ARMs). I preferred an ARM over a 30-year fixed mortgage because the interest rate was always lower. Further, given my consistent belief that we’d be in a permanently low interest rate environment, it didn’t make sense to borrow money on the long end of the curve.

In a permanently low interest rate environment, when an ARM resets, there’s a good chance it resets to a similar rate or even to a lower rate. Further, the average homeownership tenure was only about 7 years in 2003. Today, post-pandemic, the average homeownership tenure is closer to 10.5 years.

But even still, taking out a 30-year fixed rate mortgage makes no sense if you plan to sell your home after 10.5 years. Strategically, you want to match your fixed rate with your homeownership tenure to save the most amount of money.

But after so many years of taking out mortgages, refinancing them, and paying them off, a 15-year mortgage is probably the best mortgage to get, if you can afford it.

Benefits Of A 15-Year Mortgage

Below are the benefits of a 15-year mortgage versus a 30-year mortgage and an adjustable rate mortgage. If there’s any time to get a 15-year mortgage, it’s right now.

1) 15-Year Mortgage Has The Lowest Average Interest Rate Today

Back in normal times, a 15-year mortgage generally had an average rate in between a 30-year mortgage and an adjustable rate mortgage with a 1, 3, 5, 7, or 10-year duration. The reason why is that shorter-term loans are less risky and cheaper for banks to fund than long-term loans.

Put yourself in the banks’ shoes. If someone wanted to borrow money and pay you back in 30 years, you would likely charge a higher rate due to the time value of money, inflation, and the risk something happens to the borrower before the 30 years is up. On the other hand, if the borrower asked to borrow money and pay you back in a month, you might not bother to charge an interest rate.

Below is a graphic of the Treasury yield curve that demonstrates higher rates with longer durations. In normal times, a yield curve is upward-sloping. As an investor, you’ll get a higher interest rate if you invest in a 30-year Treasury bond versus if you invest in a 10-year bond and so forth. As a borrower, you’ll have to pay a higher mortgage rate for a 30-year fixed versus a 15-year mortgage or an ARM.

We Are Not In Normal Times

However, we are in a most interesting time. We are currently experiencing a mortgage market anomaly where the average 15-year mortgage is much lower than the average 5/1 adjustable rate mortgage. And whenever there is a mortgage market anomaly, you should take full advantage to save the most amount of money.

Take a look at the latest Freddie Mac mortgage market survey below. It shows the average 15-year mortgage is 2.27% versus 2.64% for a 5/1 ARM. However, it’s worth noting the average fees/points is slightly higher for a 15-year mortgage than for a 5/1 ARM.

Starting around early 2019, the average 15-year mortgage rate average began to consistently fall below the average 5/1 ARM rate (green line lower than orange line). The reason? A focus on risk-adjusted profits and supply and demand.

Lenders decided they couldn’t make enough margin on a 5/1 ARM with a 30-year amortizing period to warrant the increased risk of defaults. Therefore, the average 5/1 ARM rate didn’t decline as much. Instead, lenders began focusing on 15-year mortgages to tighten lending standards and increase their chances of getting paid back in full. With a higher monthly payment and a 50% shorter amortizing period, lenders felt more comfortable lending 15-year mortgages at lower rates.

At the same time, borrowers have decided they wanted to be more conservative and take out a shorter amortizing loan instead. With interest rates so low, why not lock in a loan for 15 years instead of only five years.

Lenders Are Still Very Cautious Today

Only those with excellent credit scores are getting approved for mortgages and mortgage refinances. This lending stringency is one of the key reasons why the housing market won’t crash any time soon. Great credit plus massive home equity gains provides a tremendous amount of cushion.

By keeping the 15-year mortgage rate so much lower than other mortgage products, the lenders are willing to give up some margin to secure longer-term profitability in an uncertain future. In other words, lenders are willing to sacrifice some margin for the added security of receiving higher payments over a shorter amortization period.

This is where you, as a savvy Financial Samurai, need to take advantage of the kink in the mortgage lending curve. As the economy continues to improve, the gap between the average 15-year mortgage rate and the average 5/1 ARM rate will likely narrow. The gap will likely continue to narrow until the average 15-year mortgage is eventually higher than the average 5/1 ARM rate.

If the average 5/1 ARM rate stays static at 2.64%, I could see the average 15-year mortgage rate increase by 0.5% to 2.75% a year from now. In other words, you are getting a 0.5% DISCOUNT by refinancing to a 15-year mortgage rate today.

2) A 15-Year Mortgage Borrower Pays Less In Total Interest 

Since a 15-year mortgage amortizes over 15 years instead of 30 years, you will pay less total interest if both mortgage rates are the same. However, the average 15-year mortgage rate is much lower than the average 30-year mortgage rate. Therefore, the combination of a lower rate and shorter amortization period results in much less in total interest payments by the borrower.

For example, let’s look at the following total interest paid over the life of a $1 million mortgage with three types of terms.

30-year mortgage at 3%: $517,777 in total interest paid

15-year mortgage at 2.3%: $183,347 in total interest paid

15-year mortgage at 5%: $423,428 in total interest paid

Even if you took out a 15-year mortgage interest rate that was 2% higher than a 30-year mortgage rate, you would still end up paying $94,349 less in interest during the duration of the loan. The power of compounding works both ways.

3) Greater Forced Savings 

Forced savings is one of the reasons why the average net worth for a homeowner is more than 40X greater than the average net worth of a renter. Once you give someone an option to do something, the conversion rate is guaranteed to be lower than 100% (forced). If the government didn’t force W2 earners to pay taxes out of each pay check, the government would be in a huge deficit if it depended on citizens to pay once a year.

Given the shorter amortization period, the monthly payment for a 15-year mortgage is much higher than a 5/1 ARM or 30-year mortgage amortizing over 30 years.

For example, a $1 million, 15-year mortgage at 3% has a monthly payment of $6,905. A $1 million 30-year mortgage at 3% has a monthly payment of only $4,216. This is a monthly difference of $2,689 for borrowing the same amount at the same rate.

In addition, if you take out a 15-year mortgage, a greater percentage of your payment will go towards paying down principal. With a $1 million, 30-year mortgage at 3%, $1,716 of the $4,216 monthly payment (40.7%) goes to paying down principal. With a $1 million, 15-year mortgage at 3%, $4,405 of the $6,905 payment (63.8%) goes to paying down principal.

In other words, every month, the 15-year mortgage holder is forced to save $2,689 more than the 30-year mortgage holder in this example. Over time, this forced savings really adds up. And if the house also appreciates over time, then an enormous amount of wealth can automatically be built.

15-year mortgage amortization table on $1 million loan at 3%
15-year mortgage, $1 million loan at 3%, $6,905/month

4) Pay Off Your Mortgage Quicker

Some people who take out ARMs or 30-year fixed mortgages like to tell themselves they will pay off the mortgage sooner. Having lower monthly payments and the option to pay off their mortgage sooner is a nice combination. However, in my experience, I’ve found we seldom stick to our mortgage payoff intentions.

For example, in 2003, I had a goal of paying off my 30-year fixed mortgage in 10 years. But I ended up refinancing the property after one year to a lower 30-year fixed mortgage. Then I wised up and refinanced the mortgage to an ARM several years later. Instead of paying off the mortgage in 2013 as planned, I paid it off in 2017. Not only was I tempted by my new lower mortgage rate, I simply didn’t pay down extra principal as regularly as I had anticipated.

With a 15-year mortgage, you can be the most unfocused person. You are guaranteed to pay off your mortgage in 15 years if you keep making your payments.

5) Potentially Less In Fees Due to Fannie Mae And Freddie Mac

If your mortgage is purchased by one of the government-sponsored companies, like Fannie Mae, you will likely end up paying less in fees for a 15-year loan. Fannie Mae and the other government-backed enterprises charge what they call loan-level price adjustments that often apply only to, or are higher for, 30-year-mortgages.

These fees typically apply to borrowers with lower credit scores who make down payments less than 20%. Private mortgage insurance (PMI) is required by lenders when you make a down payment that’s smaller than 20% of the home’s value. If you find yourself in this situation, you will pay lower mortgage insurance premiums if you take out a 15-year mortgage.

Disadvantages Of A 15-Year Mortgage 

So far, all of you should be in agreement that taking out a 15-year mortgage or refinancing into a 15-year mortgage makes a lot of sense. However, a 15-year mortgage is only great if you can afford it. Here are the three main disadvantages of a 15-year mortgage.

1) Higher Monthly Payments 

Because a 15-year mortgage amortizes over 15 years, a 15-year mortgage will have higher monthly payments than a mortgage that amortizes over a 30-year period. Being able to pay $6,905 a month for a $1 million, 15-year mortgage at 3% requires a much higher income than paying $4,216 a month for a 30-year fixed mortgage.

If we are to follow my 30/30/3 rule for home buying, a 15-year mortgage holder in this example would need to earn at least $250,000 a year (($6,905 X 3) X 12). Whereas a 30-year mortgage holder with the same terms would only need to make at least $152,000 (($4,216 X3) X 12). In other words, the 15-year mortgage holder needs to make about 61% more, despite borrowing the same amount.

Of course, someone who makes $152,000 could still pay $6,905 a month in mortgage payments for a 15-year mortgage. The disposable cash flow will simply be tighter.

2) Less Affordability (Biggest Disadvantage)

Less affordability to buy the home you want is the biggest disadvantage to taking out a 15-year mortgage. Let’s go back to my 30/30/3 home buying rule that states you should buy up to 3X your household income.

A $240,000 a year household can afford to buy up to a $720,000 home. If the household wants to stretch the multiple from 3X to 5X given rates are so low, the household can afford to buy up to a $1,200,000 home. However, the household needs to be damn sure about its income-generating future and ability to hold on during bad times.

A $240,000 a year household earns $20,000 gross a month. Based on my 30/30/3 rule, up to 30% of the monthly cash flow should be allocated to a mortgage. Hence, a mortgage of $6,000 is what is considered affordable for a $20,000 a month earner. $4,216 a month for a 30-year, $1 million mortgage at 3% is not a problem. However, $6,905 a month for a 15-year, $1 million mortgage at 3% doesn’t work with my rule.

Therefore, in order to take out a 15-year mortgage, the $240,000 a year household can only borrow $865,000 at 3% for a payment of just under $6,000 a month. Borrowing $135,000 less means coming up with $135,000 more in cash or buying a cheaper home.

Instead of buying a $1,200,000 home with a $1 million mortgage, the household buys a $1,000,000 home with an $800,000 mortgage. If the house appreciates by 5% over one year, the household loses out on $10,000 in appreciation by buying the cheaper home. Over a 10-year period, the household loses out on a significant $125,778 in appreciation/equity.

In a bull market, you want to buy the most home you can afford. In a bear market, you want to do the exact opposite and rent.

3) Less Money Going Towards Savings Or Other Investments

A higher monthly payment for a 15-year mortgage requires higher income and higher cash reserves. Therefore, your emergency fund or cash reserves will have to be higher to cover your higher monthly burn rate.

A higher cash reserve means less money going towards saving for retirement, funding a college 529 savings plan, investing in other assets, and spending on wants.

Every dollar has an opportunity cost. A 15-year mortgage has a higher opportunity cost, especially when times are very good. For example, if the stock market ends up going up 20% a year for the next three years, you may have preferred to get a 30-year amortizing loan and invest the extra cash flow instead.

Personally, I like investing in commercial real estate through a diversified fund like the ones from Fundrise. Commercial real estate is the asset class I think has the most amount of upside as the economy opens up. A potential steady annual return of 5%-8% seems reasonable, which would make up for some of the savings by not getting a 15-year mortgage.

However, nobody knows for sure how their other investments will perform. Therefore, it’s a good idea to spread around your cash flow.

The Ideal Situation To Take Out A 15-Year Mortgage

If I was forced to take out a 15-year mortgage back in 2003, I likely would not have bought the condo when I did. The increased monthly payment would have perhaps been too much. Therefore, I would have probably waited at least another year and lost out on a $46,400 paper gain. From 2003 – 2004, the San Francisco real estate market went up about 8%.

To save $46,400 in interest expense with a 15-year mortgage that is 0.5% lower than an ARM, it would take nine years and three months with a $1 million loan. In other words, among other things, take into consideration the future of the housing market when choosing the type of mortgage.

For first-time homebuyers, it is probably best to take out an ARM, followed by a 30-year fixed mortgage to get neutral the real estate market. In the past, I’ve written the best time to buy property is when you can afford it. Shorting the housing market by renting long-term is a tough way to build wealth. Inflation is too powerful of a force to go against.

However, once you’ve built up some home equity and grown your savings, I think it’s worth refinancing to a 15-year mortgage or taking out a 15-year mortgage for your next home. Over time, your income and wealth should naturally grow. Therefore, you will more easily be able to afford a higher monthly payment.

In an environment where the average 15-year mortgage rate is lower than the two other main types of mortgages, taking advantage of this anomaly is smart. It won’t last forever.

If the average 15-year mortgage rate was only 0.25% or less than the average 5/1 ARM, a 15-year mortgage might not be that attractive. But at an average discount of 0.5%, it is too wide of a spread not to pounce. And if you can get a relationship pricing discount, even better. Although, having to move a lot of funds for relationship pricing can be a real PITA.

A Race Against Time

15 years goes by pretty quickly. Let’s say you bought your second primary residence, a forever home, at age 32. Having a fully paid off home by 47 is pretty sweet.

Once you don’t have a mortgage, life gets much more affordable. Suddenly, the idea of retiring early, taking a long sabbatical, or working a more interesting but lower paying job is more feasible. With all the extra cash flow, you could invest, live it up, or do both.

If you’re looking to get a 15-year mortgage, check out Credible, my favorite lending marketplace. You can get no-obligation quotes in minutes. The more you shop around, the more you can save.

Readers, any of you take out a 15-year mortgage? Why do you think people are still taking out 30-year fixed mortgages in today’s environment?

Source
A 15-Year Mortgage Is Probably Best, But It Has One Big Disadvantage is written by Financial Samurai for www.financialsamurai.com

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