The 30 Year Mortgage Paradox
October 19th, 2006 | By Ian in Finance, Rants, Sites of Interest | 12 Comments »
Imagine you were considering your options on a $350,000 traditional home loan. Assuming you have a FICO score of 725 (US average(1)), your interest rate might be 6.259% for a 30-year fixed mortgage(2). At the end of 30 years, you’ll own your home outright for a total cost of about $776K–that’s $427K in interest(3).
By contrast, a 15-year loan will net you a lower interest rate of about 6.011%. Your monthly payments will be a little bit more, but you will own the home in half the time for a total cost of about $532K–only $182K in interest.
Assuming a paltry average annual appreciation rate of 10% (US average since 1980 has been 11.28%(4)), your house would be worth 417% it’s original value after 15 years. That $350K house would sell for about $1.5 million. Assuming you sold it and put the cash towards a bigger home costing $1.85M, taking out a new $350K loan to cover the remainder, you would only pay another $182K in interest in the second 15 years. Sell that house after another 15 years of 10% appreciation and you bank $7.7 million dollars. By comparison, the original house would sell for $6.1M in 30 years.
The net effect of the two fifteen year mortgages is living in a much better home for half the time and only paying a grand total of $364,000 in interest while neting about $1.6M more in value after 30 years. That’s quite a difference! You might be wondering why anybody would opt for a 30 year home loan.
On the other hand, you might have figured out that the 30 year $350K mortgage with its lower payments might be the most you can afford each month; that in order to make that same payment amount on a 15 year loan, you can only borrow $255K(5).
Well, that stinks. In the Seattle area, that’s 14.5% fewer houses in your price range and 20% less square footage in those you can afford (worse still if you want the same number of rooms)(6). However, it’s not all bad news. If you’re willing to go the 15/15 route, your second home would be worth $434K in today’s housing dollars(7), giving you 41% more selection and 22% more space than the 30 year home.
So what’s a buyer to do?
I suggest you start any home buying process by getting a pre-approval for a 15 year loan (higher payments, shorter term). Then, shop the market and see if you can find anything that will fit your needs for the foreseeable future. If you find a house you can call home, snatch it up and start building more equity at a faster pace. If you exhaust the market and can’t find the amount of house you need on your 15-year budget, go back to your loan agent and have them recalculate your pre-approval for a 30 year loan and resume your search.
If must choose the traditional 30 year loan, there is no need to fret. Your needs and budget simply lie in the margin between price ranges of these two loan types. Most of the home buyers out there fall into this range and the seem to be quite happy with it.
If you find you can fill your needs in a 15 year loan, congratulations; you are able to live well within your means and you will eventually reap considerable benefits from your good budgeteering.
References
#1 wikipedia.com – FICO info
#2 myfico.com – FICO/loan rate calculator
#3 moneychimp.com – Compound interest calculator
#4 ofheo.gov – US historical housing appreciation data
#5 equifax.com – Financial calculators
#6 redfin.com – House value mapping
#7 bls.gov – US historical inflation data