Home mortgage loan term options

Healthcare Financial Management, Oct, 1998 by William G. Kistner

With the significant decline in long-term interest rates during the last several years, mortgage loans with shorter terms (eg, 15 or 20 years) have grown in popularity. Assuming a person can afford the higher payments associated with a short-term mortgage, he or she needs to decide which loan term is more advantageous. Conventional wisdom seems to favor a 15-year mortgage because of the projected interest savings. For example, total interest payments on a $150,000 loan would be $200,243 for a 30-year mortgage at 6.75 percent, but only $85,199 for a 15-year mortgage at 6.50 percent.

The deductibility of home mortgage interest, however, is one of the last great tax breaks available to taxpayers of all income brackets. Generally, interest paid to buy, build, or substantially improve a personal residence is deductible, provided the debt is secured by the residence(s) and does not exceed $1 million. In the example above, assuming the mortgage holder were in a combined Federal and state tax bracket of 40 percent, the after-tax interest savings of the 15-year mortgage, while still significant, would be reduced to $69,026.

Even after taxes, the 30-year mortgage ends up costing more in interest over the long term. So why would one consider a 30-year loan? Because one may come out ahead by investing the cash-flow savings associated with the lower monthly mortgage payment. Stated another way, one could either pay off a mortgage in 15 years and then allocate the available cash flows to long-term savings and investments, or service the debt for a longer period at a lower monthly payment but start building or adding to an investment portfolio now.

Again using the above example, the monthly payment on the 30-year mortgage is only $973 compared with $1,307 for the 15-year mortgage, a difference of $334. After considering the tax savings on the interest portion of the payments, however, the after-tax differential for the initial monthly payment would be $346. (This amount would continue to increase as the interest portion of the 15-year loan payments declines relative to the interest portion of the 30-year loan payments.) Investing the additional cash flows in a diversified portfolio of securities or mutual funds on a regular (eg, monthly) basis could enable one to accumulate more wealth over the long term, depending on the portfolio's long-term performance.

Exhibit 1 illustrates the range of potential outcomes for the $150,000 loan example. The 30-year-and-invest-the-rest strategy assumes that during the first 15 years, the mortgage holder makes monthly investments equal [TABULAR DATA FOR EXHIBIT 1 OMITTED] to the additional cash flows associated with lower payments. By contrast, the 15-year loan scenario assumes that once the 15-year loan is paid in full, one then invests an amount equal to the remaining after-tax monthly payments on the 30-year loan. Results are projected over a 30-year period. The following investment and tax-rate assumptions also apply: pretax yield (interest and dividends) of 2 percent annually; combined Federal and state ordinary and long-term capital gains tax rates of 40 and 24 percent, respectively; and a 25 percent portfolio turnover rate. The pretax investment growth rate ranges from 0 to 10 percent annually.

As Exhibit 1 illustrates, the 30-year-and-invest-the-rest strategy would produce a larger after-tax investment portfolio at the end of the 30-year analysis period as long as the investment portfolio enjoyed a pretax annual growth rate of 4 percent or higher (ie, a 6 percent total return). At higher growth rates, this strategy can generate significantly more wealth over the long term. For example, assuming an 8 percent pretax growth rate (10 percent total return), the 30-year mortgage scenario produces more than $150,000 after tax at the end of the mortgage term than the 15-year mortgage scenario.

Despite the apparent wealth-accumulation advantage of a 30-year mortgage, many homeowners prefer the imposed savings discipline inherent in the 15-year mortgage. Retiring the debt at an accelerated rate is akin to making an effectively risk-free "fixed-income" investment (the interest savings associated with the debt payments is essentially equivalent to receiving interest income). Moreover, the peace of mind associated with owning a home debt-free in only 15 years may be an important, albeit intangible, factor in deciding which loan term is preferable.

On the other hand, a 30-year mortgage may appear less daunting in the face of uncertainty with respect to cash flows from employment or business. Furthermore, in the event of a future financial hardship (eg, loss of a job), it may be easier to tap an investment account with the 30-year loan than to take out a home equity loan against a large home with a 15-year mortgage.

William G. Kistner, MM, CPA, is a tax partner, Ernst & Young LLP, Chicago, Illinois, and a member of HFMA's First Illinois Chapter. Readers' comments should be addressed to him at Ernst & Young LLP, 233 South Wacker Drive, Chicago, Illinois 60606-6301.