A 30-year fixed-rate mortgage is the most popular option for home purchases. However, you probably have seen some advertisements that encourage you to refinance your 30-year mortgage into a 15-year one. If you are a Dave Ramsey fan, you know that he is against taking out a 30-year loan and encourages you to use cash for your home purchase. In the worst case, he said a 15-year mortgage is superior to a 30-year mortgage. Is a 30-year mortgage really that bad?
15-Year Mortgage vs. 30-Year Mortgage
First, let’s take a look at the difference between a 15-year mortgage vs. a 30-year mortgage assuming you’re buying a $250,000 house (the median home price in the United States). Both loans will have the same amount for the home price, down payment, and loan amount.
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We calculate the monthly payment, total interest payment, and total payment using our free amortization calculator.
The Key Differences Between 15-Year vs. 30-Year Mortgage
The main difference between the 15-year mortgage and the 30-year is
- You pay a lower interest rate for the 15-year mortgage
- You pay a higher monthly payment for the 15-year mortgage
- You pay less total interest through the lifetime of the loan using the 15-year mortgage
Based on this information alone, it is no surprise that most people jump to the conclusion that the 15-year mortgage is better than the 30-year mortgage.
30-Year vs. 15-Year in a Low-Interest Environment
Inflation-Adjusted Total Payment and Cash Flow
However, a 30-year mortgage is a much better product when the rates are low (like it is now). There are two reasons for this:
- Inflation-Adjusted Total Payment – Using the numbers above and an average inflation rate of 2.5%, the inflation-adjusted total payment for the 15-year loan is $214,995 vs. $232,965 for the 30-year loan — a tiny difference of $17,969 over the course of 30-years.
- Improved Cash Flow – At the same time, your cash flow is improved when you are using a 30-year mortgage by $6,065 per year for the first 15 years. You can do a lot with that difference in cash flow.
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Mortgage Interest Tax Deduction
Also, remember that on average, the person who is paying a 30-year mortgage is enjoying a higher tax deduction each year. Although this benefit is highly dependent on the individual’s tax situation, so we don’t include the numerical advantage here.
Invest the Difference
Even if you don’t invest the difference, a 30-year loan is much better than a 15-year mortgage when the interest rate is low. Now let’s look at what happens if you invest the difference and get an average gain of 9% per year by investing in the S&P500 Index.
After 15 years, you will have $178,075 in your investment account!
Now, let’s look at the next 15 years. After the 15-year mortgage is paid off, you invest the monthly payment that you no longer have to pay to the mortgage company in the stock market for the next 15 years. At the end of 30 years:
- 15-year mortgage and invest for 15 years result in an investment balance of $499,436
- 30-year mortgage and invest the difference for 30 years result in an investment balance of $826,711!
In fact, the 30-year mortgage and invest the difference option is better for an investment that returns on average 4% or more. At 4%, both scenarios are the same at about $340,000 in the investment account.
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30-Year vs. 15-Year in a Higher-Interest Environment
The 30-year mortgage is not always a better choice.
Assuming that you can achieve a 9% return on investment, the break-even point is around a 6% interest rate for the 15-year and 6.5% for the 30-year. This is where more in-depth analysis and personal preference come into play because either option is about equally as good.
Also, your investing skills and experience play an essential role. If you are not a proficient investor, or if you are motivated to take the extra risks, then you’re almost always better off with a 15-year mortgage. When you use a 15-year mortgage, the money you save from a lower interest rate is guaranteed, and you do not have to take investment risks.
Cash for Home Purchase
I know Dave Ramsey’s fan will hate it when I say this: paying cash for a home purchase is just plain old stupid. Of course, this statement assumes that we are talking about the current interest rates and that you don’t have enough cash to make an outright purchase.
- If you are already sitting on enough cash to buy your next house, then I feel it is not a wrong decision at all and that it is your choice to do so.
- Secondly, there is going to be a point where the interest rate is so high that it doesn’t make any sense whatsoever to take out a home mortgage, but we are not even close to being in that situation.
Here are why I think paying cash for your home right now is dumb:
- Interest rates are very low. Inflation is already erasing the majority of the interest you’re effectively paying. For example, at 2.5% inflation and a 3.75% interest rate, you are effectively paying 1.25% for your loan. That’s a fantastic deal!
- High probability of getting better returns elsewhere. Since the rate you’re paying is so low, your chance of beating the risk-free rate of paying down your debt faster is so much higher that it is better to take the investment risks.
- Saving up takes forever. If you don’t have enough cash right now, trying to save $250,000 from zero will take you many years. There are many problems with this:
- Home prices are likely to continue to climb while you’re saving up.
- Risk-free savings cannot keep up with the inflation rate, so your purchase power goes down each year even while you save up.
- Investing your money is not recommended since the market fluctuates, and you could lose your principal when you are just about ready to make your purchase.
The key point is: unless you already have the cash to pay the full price for your home purchase right now, saving up to buy a house with cash is a bad decision.
- A 30-year mortgage is better than a 15-year mortgage when the interest rate is low as it is right now.
- If you’re a proficient investor and willing to take on some investment risks, a 30-year mortgage is better until the interest rates start to hit a 6% range.
- Above a 6% interest rate, the 15-year mortgage is a better product if you can afford the higher monthly payment.
- Paying cash for a home purchase is perfectly fine if you already have the cash.
- Saving up to buy a house with cash simply to avoid debt is a bad idea because home appreciation and inflation are continually working against you. You may never reach a point where you can purchase a house.
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.