Thursday, September 12, 2013

Why we chose a 30 year mortgage when we can afford a 15 year

When we first went and talked with our mortgage broker he had suggested that based on our income and financial responsibility that we should take out a 15 year mortgage rather than a 30 year. At first we were both pretty gung ho about it because we could easily afford a 15 year note. However, once I started crunching the numbers to see how exactly our budget would look I quickly changed my mind. The mortgage note alone wouldn't be an issue to cover, but when you add in all the other expenses including insurance, taxes, full maintenance costs, increased utilities and furniture, the monthly outlay quickly rose from just the 15 year note. Adding to the risk is that my job is currently stable but far from being as stable as my wife's job as a teacher. If you've studied the oilfield, or just paid some attention to the news, over time is a very boom and bust industry. 

The numbers and risks associated with having a less than stable income led us to change to a 30 year mortgage. Reaching financial independence is all about cash flow and while we will have the mortgage payment for twice the time, the cash flow becomes easier to manage. The 15 year mortgage was going to give a payment of $1,282.05 while the 30 year gives a payment of $911.84. The difference seems small enough at just $370.21, but when you consider that our main source of passive income after reaching financial independence is going to be dividend income that would require almost $127k invested at a 3.50% yield just to cover the difference. Not to mention that should I lose my job completely and can't find new employment the costs listed above would run about 90% of my wife's paycheck and our passive income based on the 15 year but 80% based on the 30 year. Neither one is optimal but the 30 year is a little bit better.

Our plan for paying off the mortgage is to invest the difference of $370.21 for the first 15 years which will give us many more options along the way and free up our monthly cash flow for future savings. Let's define a few assumptions to see where we could be at financially at the 15 year mark by investing the difference. First is the monthly investment of $370.21, considering we're both good at budgeting/keeping track of our finances, this won't be going towards other uses. Second I'll assume that I can return an average annual return of 8% and since I'll be using a dividend growth strategy I'll assume a 3.25% average current dividend yield. You can see the calculations in the following Google spreadsheet or access the full screen version here.



After just 1 year our portfolio will be worth $4,609.09 and be churning out $149.80 in annual dividends or $12.48 per month. That would cover 1.37% of our 30 year mortgage payment. Five years out and our portfolio value would be $27,201.87 and spinning off $884.06 in annual dividends. That's good for $73.67 per month which would cover 8.08% of the mortgage payment. Going to 10 years out and the portfolio value would be $67,728.45 and paying out $2,201.17 in annual dividends or $183.43 per month which would cover 20.12% of the mortgage payment. But the 15 year mark is really what matters to determine whether this was the right move. At year 15 the portfolio would be valued at $128,106.81 and churning out $4,163.47 in annual dividends. While the monthly dividend income is only $346.96 and covering just 38.05% of the mortgage payment the good news is that our mortgage balance would be $117,228.23. Our portfolio balance would actually cross our mortgage balance at the 14 year and 3 month mark, or the 171st payment.

So at the 15 year mark we'll have a few options. We can either liquidate the portfolio and payoff the remaining balance and walk out almost $11,000 ahead or we can leave the portfolio intact and it continue to compound and grow. As of now I'm leaning towards letting it continue to compound but we're still 15 years away from making that decision. It will all depend on what the rest of our financial picture looks like at the time. If we can still live comfortably by liquidating the portfolio and paying off the balance then that's what we'll do, but if we need the dividend income then we'll probably let it keep growing.


Just some interesting tidbits from crunching the numbers. Assuming 3.00% annual inflation, the 30 year mortgage payment would be equivalent to just $581.74 2013 dollars after 15 years and $371.14 2013 dollars after 30 years. If we continued to invest the difference between the two payments it would take 24 years and 7 months for our dividend stream to fully cover the mortgage payment and we would have a portfolio value of $338,760.02. After 30 years the dividend stream would be $1,494.31 which would be 164% of our mortgage payment with a portfolio value over $550,000. 

Even though interest rates have risen over the past few months I think a 30 year mortgage is still very attractive assuming that conservative estimates of your investment opportunities can return 7-8%. Once the interest rates start to approach or surpass 6% the numbers just don't work out as well because you can take a guaranteed 6% return by paying down the mortgage or take a riskier move by investing in the markets to gain an extra 1-2% on average.

Would you go with a 15 year or a 30 year mortgage?  Did you run the numbers before making the decision if you currently have a mortgage?  Surprised by the results?

16 comments:

  1. WOW great post. Not only does it show picking a 15 year or 30 year mortgage will be better, but it shows the people that with just $370 a month every month for 30 years they can have over half a million for retirement.

    Great post.

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    Replies
    1. FFDividend,

      With interest rates still relatively low leveraging for the longest time possible is the best route. My only regret is that we didn't do this sooner or pick up some rental properties. The power of compound interest and time is a true beast. 8% should be a good estimate of what you can earn over a 30 year span if you invest in solid high-quality companies so the fact that you can have over half a million is amazing.

      Thanks for stopping by!

      Delete
    2. Passive IncomePursuit,

      I also was looking for rental properties, but I got in late and it was not worth it to me any more. Now I am doing dividends.

      Good luck to you.

      Delete
  2. Yeah, I love how $370 dollars a month for 15 years grows to become so much

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    1. Lee,

      It's all about being disciplined but what part of personal finance isn't? In 15 years we can come out over $10k ahead which is great!

      Thanks for stopping by!

      Delete
  3. Pursuing Financial FreedomSeptember 12, 2013 at 3:13 PM

    I enjoy taking advantage of both options. I get a direct result in paying a little extra on my mortgage but still chose a 30 year term to keep my obligation low and increase my investment opportunities. I have another recommendation for analysis, since I see your analysis on Visa was such a success. (I now see many DGI bloggers that I follow mentioning a new position in Visa!) I would love to see an analysis of Stryker (SYK). On FAST Graphs it appears undervalued and the DG history is superb. Keep up the good work!

    ReplyDelete
    Replies
    1. PFF,

      I think it really depends on the rate on your mortgage. If it's over 5% then I'd seriously consider putting more towards the mortgage. Over 7% and most of my free capital would be going towards the debt. But it really comes down to what you're comfortable with. As always personal finance is personal so you have to do what you feel is best. I think in most situations though a 30 year is always the best choice over a 15 year despite the higher interest rates. The added flexibility and extra cash flow between the payments is a big plus.

      I noticed that too about Visa. I think V is a great opportunity although it's not exactly the purest of DG stocks because the yield is so low. I'll work on getting an analysis on Stryker up sometime next week. I'll be too busy the rest of this week and the weekend but things should slow down once I head back to work since I'm in front of a computer all day.

      Delete
    2. Pursuing Financial FreedomSeptember 13, 2013 at 2:02 PM

      PIP- you are correct. With my 4.875% interest rate, I have determined the best plan of action is to split up my free capital between paying extra on the mortgage and increasing my brokerage accounts. I feel I am winning either way. I'm also looking into refinancing into a 20 year term soon (sucks I couldn't get this done 8 months ago!). This will lower my term, allow me to get rid of PMI and decrease the total amount of interest paid. The great thing is, depending on rates, I'm not far from paying the exact same amount per month! So it's a no-brainer. Thank you for doing the STRYKER analysis. I'm sure you will be pleasantly surprised, as I was with the results. Keep up the good work!

      Delete
    3. PFF,

      With an interest rate under 5% I think it's probably best to invest for the long-term but you can't go wrong with splitting your free capital to pay off the mortgage and invest. The problem lies when you decide that spending that extra money is the best route, especially if none of it ever gets saved. Best of luck with the refi, getting rid of PMI will be a huge boost even if the refi to a 20 year just keeps your payments the same. PMI is such a scam in my opinion and the quicker you can get rid of it the better.

      Thanks for stopping by!

      Delete
  4. I think I'd probably go the 30 year route too. It's nice to have less commitment and more options. I think you ought to factor in mortgage interest tax deductions and also dividend tax to be fair.

    Could you not simply choose to apply the 370 towards principal? Perhaps ramp up investments when the markets are cheap and ramp up mortgage payments with a guaranteed return when nothing else seems attractive? Having choices is a good thing since you are very disciplined financially! Most people would just spend the 370, but I know you will not.

    ReplyDelete
    Replies
    1. CI,

      Well the main comparison is between the 15 year vs 30 year mortgage and investing the difference to see which one comes out ahead. Granted will still end up paying more interest over the 15 years if we liquidate the investments to pay off the mortgage but it allowed us to have more cash flow the whole time.

      I've never bought a house before and have just barely researched how the taxes are handled but I'm not sure that we're going to even be able to take advantage of the mortgage interest deduction and property taxes. Accounting for the mortgage interest/property tax deduction is hard to forecast due to tax laws. I don't expect the deductions to go away because too many taxpayers rely on them but the tax bracket we end up falling in will vary between 25%, 28% or possibly in a really good year 33%. I know some of the deductions start getting phased out but I'm not sure where. Actually looking at the numbers, the 30 year is even better because while we pay more in interest it will get us over the standard deduction amount while the 15 year wouldn't.

      I had thought about putting it towards the principal every month but due to the lower interest rate on the mortgage compared to the growth of the investments it won't work out mathematically. Applying the difference to the principal would get the mortgage paid off in 197 months or 16 years and 5 months. So it would take longer to pay it off doing it this way. If I feel that the markets get way overheated then I might stop the investments and put it towards the principal but who knows. It's still so fluid at the moment. Of course by investing it's anything but a sure thing so there's added risk there.

      Thanks for stopping by!

      Delete
  5. I did my numbers crunching math and also decide to take 30 yr loan rather than 15 and i invest all the remaining money. I calculated that with my current investing rate of return I will have saved the entire loan amount in 16 years. Then I can decide whether to pay the loan off or just keep it and continue saving. why would I pay off a loan with 3.5% interest rate when my investments bring me in 15.7% rate?

    ReplyDelete
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    1. Martin,

      Even with the rise in interest rates, it's still a pretty low hurdle to beat around 5% interest. Just DCA into a S&P500 index fund should get you there over a 15+ year period.

      Thanks for stopping by!

      Delete
  6. Good post. For me I would always choose a 30 year because I want the flexibility of choice. Yes I know that many people say that with the expectation of paying extra on the loan but never do.
    I want choice of where I invest the money. Maybe payoff the loan early. Maybe put extra into dividends. Maybe get back to lending club.

    There is also a psychological aspect. Less cash flow makes me feel restrained and that I do not have freedom and choice. Though I have 33%-40% of my take home pay going towards multiple investing routes I feel like I am falling behind with only 20% though I realize many would kill to be in that position.

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    1. PMU,

      The 30 year seems to be the best route, especially given the low interest rates. If you're disciplined enough to actually invest or pay extra then the 30 year makes sense because as you mentioned is the flexibility. The 15 year is just going to make the budget tighter which to me isn't worth it since you can invest the difference and come out ahead.

      To your last point, I think a lot of people can get to 20% or 40% savings but either they lack the knowledge, motivation, or dedication to do so on a consistent basis. Too many people just see what's left over at the end of the month as fun money or found money.

      Thanks for stopping by!

      Delete
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    ReplyDelete