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Take Out a 30 Year Mortgage to Pay Off in 15 Years? At What Cost?

Updated: Nov 17, 2022

I've repeatedly heard people say that they were taking out a 30 year mortgage rather than a 15 year mortgage even though they planned to pay off the mortgage in 15 years. The reason for this move is so that they if they ran into difficult times, they could pay the lower 30 year mortgage payment rather than the higher 15 year mortgage payment. In other words, they wanted to retain flexibility.

Flexibility in one's finances is a very good thing. In this case, being able to reduce the monthly outlay for one's mortgage could be useful in the event that one's income dropped and/or spending increased.

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But in this case, there is a significant cost to the flexibility of this approach: a substantially higher interest rate.

As of today, Nerd Wallet reports that the average 30 year mortgage rate is 6.38%, while the average 15 year mortgage rate is 5.56%. That .82% difference might seem small, but it isn't.

The median sale price of a house in the U.S. is currently about $455,000. Assuming that price, a 20% down payment, and a mortgage balance of $364,000, a 30 year mortgage at a 6.38% rate would have a principal and interest payment of $2,272. If this was paid over a 15 year period with the same 6.38% interest rate, the monthly payment would be $3,147, and the total amount of interest paid would be $202,460.

By comparison, a 15 year mortgage with a 5.56% rate would have a principal and interest payment of $2,986, and the total amount of interest paid would be $173,480.

That's a difference of $28,980, $161 per month for 15 years.

This does not take the time value of money into account, so the inflation-adjusted difference would be smaller than $28,980, but the point remains that the financial cost of the flexibility offered by this approach is quite substantial.

Here's a simple alternative: take out a 15 year mortgage but first increase the size of your emergency fund to account for the higher monthly payment. If you wanted your emergency fund to be 6 months of your expenses, the amount needed for the 30 year mortgage, if paid over 30 years, would be $13,632 ($2,272 x 6). The amount needed for the 15 year mortgage would be $17,916 ($2,986 x 6), $4,284 more than for the 30 year mortgage. If that additional $4,284 enabled you to save $161 per month by holding the 15 year mortgage, the effective, tax-free rate of return on those funds would be an incredible 45% per year! If you wanted 3 months of your expenses in your emergency fund, the difference between the 30 year and 15 year mortgages would be half as much, but the savings would be the same, increasing the effective, tax-free rate of return to an astounding 90% per year!

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Some might argue that a bigger emergency fund could be inadequate because you might need to make a smaller mortgage payment for longer than 3 to 6 months. That's possible, but I would argue that the best strategy in that situation is not to extend the length of your mortgage by 15 years. Rather, one might temporarily reduce the amount being saved into things such as retirement accounts. If that is inadequate or seems likely to extend well into the future, then the most logical, though not painless, choice is to sell the home and find a lower cost housing option. Trying to hang on to a home that you can no longer afford is not wise.

In truth, I suspect that relatively few of those who intend to pay off their 30 year mortgage in 15 years succeed. The siren call of paying the lower amount 'just this month' to spend those funds elsewhere is likely too great for many.

Some have argued that a 30 year mortgage is better because its monthly savings over a 15 year mortgage can be invested. This is true, but using current interest rates, the rate of return on the invested funds needed to simply break-even is fairly high. A 7.75% after-tax return would be needed for investing the difference in payments between a 15 and 30 year mortgage to favor a 30 year mortgage; anything lower would favor a 15 year mortgage. For the sake of comparison, the annualized return of U.S. stocks over the last 20 years was 9.94%, but this would be significantly lower after taxes were accounted for and was far from guaranteed. A risk-free, tax-free return of 7.75% is almost impossible to find.

Flexibility is a worthy aim for those seeking to steward their resources well, but it is not worth any price. Taking out a 30 year mortgage that one intends to pay off in 15 years simply to retain the option of making the lower payment if needed does not seem like a shrewd choice.

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