NEW YORK (MainStreet) -- Mortgage shoppers who have spurned 15-year loans in favor of 30-year deals should think again: unusually large discounts on 15-year rates make these loans unusually appealing, especially when investment alternatives are taken into account.
The 15-year loan always charges less than the 30-year loan, because the lender faces fewer risks over the shorter loan term. But that rate “spread” is often not enough to overcome the shorter loan’s downside -- a much larger monthly payment to retire the debt twice as fast.
Now the spread is unusually large. The average 15-year loan charges just 3.2%, compared to 4% for the 30-year loan, according to BankingMyWay data. That spread, 0.8 percentage points, is considerably higher than the typical spread of 0.5 points or less.
It may sound like a small difference but can add up over time. Think of it this way: the 30-year loan, at 4%, charges 25% more than the 15-year loan.
For every $100,000 borrowed, a 30-year loan at 4% will charge $477 a month, with interest totaling $72,000 over 30 years, according to BankingMyWay's mortgage loan calculator. The 15-year loan at 3.2% would charge $700 a month, with interest totaling just $26,000, a $46,000 savings.
Traditionally, there are two reasons not to take the 15-year loan.
First is its larger payment, which makes it harder to qualify for the loan in the first place. Even if you can qualify, the big payment could be a problem if money gets tight. This remains an issue despite today’s bargain rates.
But the second issue varies in importance as market conditions change. This concerns the investment gains one might enjoy by taking out the 30-year loan and investing the savings from the lower monthly payments.
Jack M. Guttentag, an emeritus professor of real estate at the University of Pennsylvania’s Wharton School, says on his website, The Mortgage Professor, that the investment issue is more likely to favor the 15-year loan when rate spreads are especially high and returns on other types of investments are not particularly promising -- today’s conditions.
In his example, Guttentag assumes a 4% rate on the 30-year loan and 3.125% on the 15-year. He calculates the rate of return one would have to earn on the monthly cash saved with the 30-year loan to make up for the higher rate that the loan charges. This “breakeven rate” is larger when the gap between the 30- and 15-year rates is wider.
In his example, the breakeven rate is 6.15%. To make the 30-year loan more profitable than the 15-year loan, you’d have to earn at least 6.15% on the extra cash, a very difficult challenge at a time when 10-year Treasury notes yields less than 2% and five-year certificates of deposit just under 1%. You might beat 6.15% in the stock market, but only by shouldering significant risk.
Because it is so hard to earn such a handsome return, the 15-year loan really is more profitable, Guttentag concludes.
Guttentag also looks at the results if the homeowner did not have the property for the full 15 or 30 years. In that case, the breakeven rate is even higher, because in the early years the 15-year mortgage pays down the loan balance much faster than the 30-year loan, allowing the borrower to build equity with the 15-year loan.
For a borrower who will have the loan only 10 years, the breakeven rate would be 8.02%. It would be 13.69% for the borrower who keeps the loan only 5 years. Even a risk-loving stock investor would be foolish to count on such a return year in and year out, making the 15-year loan the better deal -- for the borrower who can handle the bigger payments.