The Opportunity Cost Factor of a Mortgage
Buying a home may be the biggest financial decision of your life. To this point it has been true for me. And after working in real estate and the financial sector I think I can attest to the importance of understanding the elements of a mortgage. It's not just about the interest savings of a 15 year mortgage or the lower monthly payment of a 30 year, mortgage (assuming equal fixed interest rates). The bigger picture is the opportunity cost of those mortgages.
Investopedia defines opportunity cost as the potential benefits an individual, investor, or business misses out on when choosing one alternative over another.
Before getting into why I feel one is a better financially let's take a look at the pros and cons of each mortgage. I'm also inserting a comparison of the loans (using the same interest rate for both) so you can see the difference in monthly payment amount, interest paid, etc.
The 15-year mortgage:
👍 Less cumulative* interest paid
👍 Lower interest rate
👎 Shorter time, higher payment, lower monthly savings
Any additional cash flow applied to the mortgage to build home equity
*cumulative: simple addition of all payments
The 30-year mortgage:
👍 Typically less actual net compound** cost
👎 Higher interest rate
👍 Longer time, lower payment, higher monthly savings
👍 Any additional cash flow applied to a “side fund” builds savings outside of the equity
Loan amount: $250,000
15 year mortgage: monthly payments are about $1,912.
30-year mortgage: monthly payments are about $1,266.
At first glance most people key in on the added interest payments and long payment period of a 30 year mortgage, and may favor a 15 year mortgage if they can afford to. Dave Ramsey and and other popular financial "gurus" advocate to get the 15 year for those reasons, pointing out the bottom line difference in interest payments. And it is significant. But there are downsides. Below is some clarification.
What often goes unrecognized in conventional advice is the failure to acknowledge the fact that realistically, the 30-year mortgage offers more financial freedom and opportunity. This can equate to more money in your pocket.
To better understand this line of thought you have to understand the concept of the future value of money.
The Future Value of Money
This is likely a concept you've never been introduced to because it's not talked about frequently by financial planners or even taught because it requires a different way of thinking and viewing your money. It means viewing the value of money today through the lens of it's potential.
Using the Future Value calculator, let's look at the opportunity of putting those dollars to work somewhere else.
If you had saved that same $250,000 over a 30-year period, at a rate of savings that matched the interest payment of the mortgage loan, you'd have almost $1 million in money potential. This means if you had a way to use the same $250k (amount of the mortgage loan) to invest at a rate of return equal to the interest rate (4.5%) you'd generate $961,925 over the same 30 years.
If you saved the different between the 30 & 15 year mortgage ($646/month x 360 months = $225,968) and applied the future value of it over the course of 30 years at 4.5%, the potential is an impressive $869,457.
Now you might read this and think to yourself, "I'm not the financial type so that thinking doesn't apply to me." Or, "If I'm going to invest the money I already have other accounts or opportunities. I'd rather just contribute more to my retirement or just save that money outright." I hear that and understand that. Been there, done that. To be honest that was me to a "T" (Mrs. Financial Prepper writing this entry) until I overcame my fear of finances and learned more. It's amazing how education, and I'm not just referring to "classroom or book knowledge", can change your view of things and your comfort level with approaching topics. After reading books and watching videos, having conversations with those more knowledgeable than myself, scouring tons of financial websites and blogs, even YouTube videos; the fear of not understanding went away and I was able to clearly think for myself and decide how I felt about my finances and what approach I would take moving forward. I learned that money just sitting in a savings account actually loses over time value due to inflation. And that was my main way of saving! I also had a 15 year mortgage on my house. I wish I knew then what I do now!
Harnessing the Potential of the Future Value of Money Without Risk
It is entirely possible to use the monthly money savings from the 30 year payment to achieve the potential illustrated above. Seriously! Without risk.
If you use a specifically designed whole life insurance policy as a savings vehicle, your money can grow at a much higher rate than typical savings. On average a guaranteed return rate of 4.5%, which is the model used in the illustration above, plus non-guaranteed dividends, which could total up to another 4.5-6%. That's a potential for close to 9-10% rate of return. This is no joke, astounding! And when you want to jump on an opportunity, you can borrow against the cash value without reducing what’s in your account. This way your account will continue to grow!
To make it even more understandable... you could save $112,000 with the 15 year mortgage OR, make $869,000 (that's a +$757,000) by taking a 30 year mortgage and using this financial strategy. At this point you should be asking yourself, "Why wouldn't I consider this?"
Outfitter Wealth specializes in educating people so they can make the best decisions for their financial future. Education is free. 👍 And so is talking to us about your finances and how we can help take control of your money to improve your financial future. Don't hesitate to set up a time to chat. No obligations. Just an opportunity to learn and grow.
Bottom Line
I would encourage anyone purchasing or even re-financing a home to seriously consider a 30 year fixed mortgage over a 15 year, hands down. Doing so keeps you in control of your assets and your home. It provides the option to keep money where it’s liquid and accessible, not locked up in home equity. And remember you can always pay down the principal if you feel so inclined to pay it off early. I would also encourage anyone to seriously consider a cash value whole life insurance policy. Again, before I knew different I was pumping money into a term policy that I could not convert and did not provide anything close to the value and benefits I now have with a cash value policy. Again, the more you know! 👍