Monday, September 27, 2010

Mortgage Math for Boomers

There was a discussion on a popular morning business show about whether the interest rates on long-term, 30-year mortgage rates could ever get to one percent. They could, theoretically  get that low and it would certainly fix a huge amount of problems.  But most economists can't envision it ever happening based on the way our current bond market is structured. In the meantime, what should we do if we are close to retirement?

Yes, folks are still out there looking to purchase a mortgage. And yes, they, like the banks, are doing the calculations about what would be better for them: short-term loans or the traditional, long-term, 30-year variety. While the differences often seem easy to spot, on the surface at least, the nuances are harder to decipher.  The 15-year mortgage comes with a lower interest rate but because of the length of the loan, the monthly mortgage payment is higher.  The 30-year mortgage on the other hand offers a lower monthly payment but you end up paying more in interest over the life of the loan.

Those are the easy to see differences between the two.  The choice is also easy and depends on not only who you are as much as how your history of handling money plays into the equation. If you consider yourself disciplined, you might want to pick the longest term mortgage for several reasons, one of which stands out: flexibility.

Locking your cash into the higher mortgage payment will pay off the loan quicker and over a fifteen year period, cost less in terms of interest rate.  What you sacrifice is the ability to plan for the unknown.  Among those unpredictable moments that life can throw your way is a sudden change income, unexpected medical bills,  the chance that during that period, you may find another job that would force you to move.  Locking yourself into the higher monthly payment may have a negative effect on your retirement investments as well.

The person considering the 30-year mortgage can see some significant savings in terms of monthly outlays. On a loan of $300,000 spanning 30-years at 4.5%, the monthly mortgage payment would be around $1500 a month.

That same loan at a lower 15-year rate (currently about a half percentage point lower than the 30-year) the monthly payment would be about $700 more.  Looking into the future, when both loans are satisfied, the difference in interest savings can be sizable.  The 15-year mortgage would cost you about $100,000 over the original mortgage; a 30-year would show a lifetime interest payment of about $248,000.  You are going to pay interest.  The question is: Is paying $148k more worth the lower monthly payment.

While it does depend on who you are and the answer laid in bare numbers seems obvious, the statistics indicate that the longer loan is actually a better use of your money than the shorter term loan.  Conventional wisdom suggests that if you invest the saved dollars each month, you might be able to best the difference.  This requires not only investment savvy and consistent investment, but the long-term cooperation of the markets. Few have all of these attributes in place and are able to execute them without, at some point down the road, making a mistake.

There is a better argument for the long-term loan as opposed to the shorter one. If the mortgage holder of the long-term loan paid additional money to the principal each month, they could conceivable shave years off the mortgage.  In this case, an additional payment earmarked for the principal, could bring the life of the loan down just as quick as the loan for the shorter period of time.

It works like this: If the 30-year mortgage holder paid a thirteenth month payment ($1500 divided by 12 = $125) over the course of a year, they would have satisfied the loan in about 23 years.  Make a fourteenth month payment ($250 extra each month, directed towards the principal) and the loan would be paid off in about eighteen years.

Make a fifteenth month payment ($375 each month, directed towards the principal) and you would essentially have 15-year mortgage for about $325 a month.

Because mortgages are calculated each month, (interest against what is owed), by directing more money to the principal each money and doing so early on, you will also lower the amount of interest rate owed as well.  Of course your savings depends on the interest rate you get.  But the difference can be quite remarkable and will get you closer to what the 15-year mortgage holder received over the life of their loan.

You also need to consider the inflationary magic a mortgage works.  While inflation is somewhat benign now, it is not expected to stay that way forever.  If it starts to tick up, your dollar with be worth less, giving you less in terms of purchasing power.  Unless you have a fixed loan.  This could be quite sizable in terms of future savings.

Suppose your $1500 was effected by a 4% inflation rate over the next fifteen years.  In terms of purchasing power, that $1500 would be equivalent to $4865. ironically, you mortgage payment stayed the same.

You also need to consider the saved dollars -after you made the fifteenth month payment.  Invested in a super-conservative fashion, say in a Vanguard US treasury fund (VUSTX) and if the past is any indication of the future, your yield would average around 8%.  Even if that fell to almost half, you would still be on par with the owner of the shorter-term mortgage.

This sort of flexibility allows for those hiccups in our daily lives to happen and do so without creating financial hardship. And it is avoiding those potential mishaps and possibly profiting when they don't occur that is key to ensuring that we have enough to pay our bills and invest in our retirement futures.

Paul Petillo is the Managing Editor of and a fellow Boomer

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