Long-Term Mortgages Usually Make More Cents

Trying to save tens of thousands of dollars in interest charges, conservative home buyers and owners seeking to refinance are flocking to 15- and 20-year mortgages instead of the traditional 30-year variety.

But many financial experts say these borrowers are turning to shorter-maturity mortgages at the absolute worst time.

Thanks to a combination of low mortgage rates, rising tax rates and relatively strong potential returns in stocks and other investments, borrowers can end up thousands of dollars richer by choosing the 30-year mortgage instead. That’s largely because 30-year loans will have lower monthly payments than shorter-term loans; homeowners can invest the difference and earn enough over the years to more than offset the added payments in later years.

Nonetheless, nearly one out of every two homeowners who refinances today opts for a short payoff of 15 or 20 years, says Robert Van Order, chief economist at the Federal Home Loan Mortgage Corp. (Freddie Mac) in Washington.

The shorter loan term allows homeowners to secure a slightly lower interest rate and eliminate 15 years worth of interest charges.

On the surface, that’s a compelling argument for a 15-year loan, acknowledges Tim Kochis of the San Francisco financial consulting firm of Kochis & Fitz. But, when you delve more deeply, you find that you lose more than a dollar in tax breaks and “opportunity” costs--what you could make by investing the savings elsewhere--for every dollar you save, he says.

How so? Thanks to historically low interest rates, you can reasonably expect to earn more on your long-term investments than you pay on your mortgage borrowings, particularly when you consider the tax advantages of mortgage interest expenses. Over the long haul, that means the person who borrows long term and invests the difference can be thousands of dollars ahead of the person who uses their excess cash to pay off their mortgage.

Consider two hypothetical borrowers, Jane and John.

They both have $100,000 mortgages that they’re refinancing. They’re both 35 years old, have no long-term savings and both have $895 a month that they can invest either in their mortgages or elsewhere. They both want to retire at age 65, at which time they plan to have no mortgage payments and live off the amount they’ve saved and invested.

John opts for the 15-year loan. It’s got a 6.93% interest rate and requires a $895 monthly payment. When his mortgage payments are complete, John will put the $895 a month in a 401(k) retirement-savings plan that’s invested in equity mutual funds, where he earns an average 10% return.

Jane takes the 30-year mortgage at a 7.4% interest rate. Rates on 30-year mortgages are generally between 0.4 and 0.5 percentage points higher than 15-year loans, according to Keith Gumbinger, analyst at HSH Associates in Butler, N.J.

Her monthly mortgage payment amounts to $692. She invests the $203 difference in a 401(k) plan that’s also invested in equity mutual funds earning an average 10% return. She continues to divide her $895 in investable income between the mortgage and the mutual funds throughout the 30-year period.

At the end of 30 years, they have both invested $322,000 and they both own their homes.

What about their savings? John has $370,951. Jane has $458,879.

Jane’s magic was simply to earn more on her investments over a long period of time than she paid on her borrowings. In a sense, she earned interest on somebody else’s money--a concept that’s made many a banker wealthy.

But is it realistic to assume Jane can invest her money at a higher rate than what she pays on her mortgage borrowings? If she’s investing in stock funds, absolutely, says Ernie Mysogland, senior vice president and chief investment officer for Northstar Funds in Greenwich, Conn.

People tend to think of stocks as a risky investment because stock prices fluctuate--sometimes dramatically--over short periods, Mysogland notes. But when you’re investing for the long haul, the stock market’s performance looks much more stable. In the 45-year period following World War II, stocks have posted an average annual return of 12.1%, Mysogland notes.

Over that period, the nation has suffered recessions, wars, political upheaval, soaring and plunging interest rates, so it wasn’t a uniquely positive period for stocks, he says. There’s no reason to think that the stock market is going to perform differently over the next 30 years, he adds.

What about the impact of taxes? In this case they tend to even out. Jane gets greater mortgage interest deductions, particularly in the early years. John makes larger 401(k) contributions, thus deferring taxes on larger portions of his salary, in the later years.

Nonetheless, financial advisers say there are instances--even in today’s investment environment--when a 15-year mortgage does make sense. Namely, if you are older and don’t have time to wait out stock market gyrations, it may be safer to pay off the loan. Also, if you’re undisciplined and know you would spend the $203 difference instead of saving it, you’re better off paying off the mortgage.

“A 15-year mortgage isn’t a bad idea, there’s just something better,” says Kochis. “And given the numbers we’re looking at today, the alternative is much better.”