McArdle on 15-Year Mortgages
By David Henderson
Megan McArdle has a good post on why it can make sense to switch from a 30-year to a 15-year mortgage. I agree with most of her reasoning. Her point that I think is most important for most people, based on my observations of lots of people over many years, is that a 15-year mortgage, compared to a 30-year mortgage, is a way to make yourself save. For her and her husband, as for my wife and me, this doesn’t apply because we have greater than usual discipline in saving.
I want to point out one misleading statement, though, not one that’s wrong, but one that’s misleading. I also want to point out one factor that goes in favor of a 30-year mortgage.
The misleading statement:
Over the life of your loan, you’ll save 65 percent of your total interest costs. On a 30-year loan at current rates, you’ll pay almost $300,000 in interest costs on a $350,000 loan, versus about $100,000 on a 15-year loan. The benefit comes from two things: shortening the payment term, and lowering your interest costs. I don’t know about you, but I could find something to do with an extra $200,000.
If by “lowering your interest costs,” she means simply that you get a lower interest rate by switching to 15 years, then I have no objection. Her reasoning is accurate. But the “shortening the payment term” part is misleading. It’s accurate. But it’s misleading. To separate out the effects, assume that the interest rates on a 15-year and a 30-year mortgage are equal. Then, the reason you’re paying so much less interest is entirely due to a shorter term. Why do I say she’s misleading? Because it ignores the whole point of borrowing and the whole point of interest. Interest is the price for current command of resources. You have fewer resources currently if you pay the loan off faster. I can’t judge, nor can Megan, which is better for you. But we can say that it’s misleading to add up interest costs, undiscounted, over a long period. It treats a $1,000 payment on interest in the 15th year as equal to a $1,000 payment of interest in the first year. In other words, ironically, it ignores why interest exists. And that’s what she did to get her $300K vs. $100K comparison. The interest payments on the 30-year loan should be discounted back to today, as should the interest payments on a 15-year loan. Indeed, of course, if you use the same interest rate you’re paying to discount interest plus principal on each mortgage, you’ll get that the present value of each is exactly $350K. I’m not saying that that’s the right interest rate to use to discount those payments. The right interest rate will depend on your investment alternatives. If you use a higher interest rate than the one on the mortgage you’re paying, because your investment alternatives are really good, then the present value of payments on the 30-year mortgage will exceed the present value of payments on the 15-year mortgage. That suggests going with the 30-year, all other things equal. And, of course, vice-versa.
The factor that goes in favor of a 30-year mortgage over a 15-year is the threat of higher inflation. Megan writes:
Interest rates are going to have to go up sometime soonish. Mortgage rates are not at their all time lows (more’s the pity). But they’re still very low, and by refinancing now, you can lock in 3 percent or so. As inflation rises, this will ultimately mean that your mortgage loan is practically free. But this state of affairs cannot last forever; the Federal Reserve will eventually be pulling back on credit, and you will not be able to get such a good deal. Why not lock it in now?
But that argues for locking in a low rate. It doesn’t argue for switching from a 30-year to a 15-year mortgage. True, you’ll probably get a lower rate by switching. But that’s separate from the issue of inflation. If you expect higher inflation in the future and you expect that inflation to stay at that higher level, that argues for the 30-year mortgage over the 15-year mortgage because the 30-year mortgage leaves more principal for inflation to whittle away. Other than a handful of gold coins, I have few good inflation hedges. My fixed-interest-rate loan is one of them. The more slowly I pay it off, the longer I keep my inflation hedge.