It’s a question that is frequently asked by homeowners and real estate investors around the nation:
Should I go with a 30-year mortgage and have a lower monthly payment, or should I go with a 15-year mortgage and pay off the loan much faster?
However, if we rephrase the question, expressing a goal, we can certainly come up with an answer to help homeowners and investors understand which type of loan IS preferable.
So, for the purposes of this article, we will frame the questions like this:
If my goal is to give myself the greatest statistical probability of building more wealth over time, should I go with a 30-year mortgage and have a lower monthly payment, or should I go with a 15-year mortgage and pay off the loan much faster?
The short answer to this question is this:
Go with the 30-year mortgage, and especially so in this current market of low interest rates.
If you are a bit of a math nerd and want some statistical analysis behind why the 30-year mortgage is superior to the 15-year (or even shorter loan periods), read on.
Here are some of the key assumptions that go into this model:
- I assume that property prices and rents will increase with inflation at about 3.4% per year.
- I assume that interest rates are about 3.5%.
- I assume that expenses related to maintaining the property will be about 50% of the rent the property would collect.
- I assume that rents are about 1/10th of the value of the property.
- I assume that the stock market produces 11.5% annual returns.
Some or maybe all of these assumptions might be things that you disagree with. I recognize that there is no consensus for those assumptions and invite you to go ahead and download my model and play with them. It’s possible that some cases, changes to the assumptions in this model might result in situations that favor the 15-year loan, though I expect those cases to be the exception, not the rule. Note that I do not make assumptions for the following:
- Differences in interest rates: This might favor the 15-year loan, as 15-year loans might have lower interest rates.
- Tax implications: For homeowners and real estate investors, interest is tax deductible. This might favor 30-year loans further, as the mortgage interest is partially offset.
In this model we compare three scenarios:
- Buying a property with 20% down on a 30-year loan
- Buying a property with 20% down on a 15-year loan
- Buying a property with 100% cash and no loan
Let’s compare some of the key metrics going on over 30 years in these two charts:
OK, so let’s point out something right off the bat. Real estate, on average, performs worse than the stock market when bought completely with cash. It is only with leverage that average real estate returns begin to exceed the returns offered by stocks over a long period of time. You can see that in year one, both a 30-year and a 15-year loan produce high average returns for investors. This is because the property is at its most leveraged point during this timeframe.
The reason for this is that leverage amplifies returns. If you buy a house for $100,000 in cash and it increases in value by $10,000, you’ve made 10% on your money. If you buy a house for $100,000 with a down payment of $20,000 (a loan of $80,000) and it increases in value by $10,000, you’ve made 50% on your initial $20,000 investment.
Over time, as you pay down the loan, and as the property appreciates in value with inflation, your leverage decreases. To continue our example, if in 10 years you’ve paid down 25% of your $80,000 loan (balance is now $60,000), and the property has increased in value to $120,000, you are now leveraged at 50%. As your leverage decreases, so does your return on equity.
So our first chart now makes sense—the return on equity is lower for less leveraged real estate, on average. You pay down the loan faster on a 15-year mortgage and therefore have less leverage each year than with the 30-year loan. Therefore, your return on equity is lower with a 15-year loan than a 30-year loan.
If you look closely at the graph, you’ll notice that the return on equity for the all-cash investor increases over time and that once you pay off the loan in year 15 for the 15-year loan investor, the returns also increase (that’s the bend in the red line in the graph).
The reason for this is that this model assumes that all excess cash flow is reinvested, in this case in the stock market. An investor with a 15-year loan will produce less cash flow than either the all-cash investor or the investor with the 30-year note for the first 15 years and therefore will not be able to reinvest that cash flow.
It is that reinvestment of cash flow that separates the 30-year note investor from the 15-year note investor. The investor with a loan term of 30 years will have lower payments, will generate more cash flow up front, and will be able to reinvest those cash flows sooner than the investor with a 15-year mortgage. Only for a brief snapshot in time—a handful of years after the 15-year mortgage is paid down—will one see higher cash flow in the case of a 15-year note.
This is why the investor with the 30-year note has both more net worth and more cash flow at the end of the period we look at in this study. The reinvested cash steadily compounds to build a portfolio that appreciates with the stock market and spits out regular dividends.
Over time, the effects of more leverage and greater cash flow compound to the extraordinary advantage of the investor with the 30-year loan:
Does this analysis necessarily mean that a 30-year loan is right for you? Like I mentioned at the beginning of this article, the answer to that question is “it depends.” There are many reasons why a 15-year loan might be better for youthan a 30-year loan. Maybe you prefer to be debt-free as soon as possible. Maybe you don’t think you have the discipline to reinvest the cash flows as soon as you receive them.
How you view your life and your personal finances is completely up to you.
But if your goal is to choose the financing that will help you create as much wealth as possible over time, then a 30-year loan is likely to be a better bet for you than loans of shorter timeframes.
Just remember, even with a 30-year loan, you begin to deleverage to the point where you are no longer earning returns in significant excess to those historically produced by stocks, on average, about 7-10 years into the loan cycle.
It’s important to revisit your goals every few years—you might find that it’s time to refinance and buy more property, or you be content to coast on the cash flow you’ve created already, acknowledging the possibility of declining overall returns.