Choosing the right mortgage and the time value of moneyWhen choosing a mortgage loan, it’s essential to look at all of the facts. Buying a home is a huge financial decision. Being equipped with the right knowledge will ensure you and your clients have the right strategy.

A 15-year mortgage has the appeal of a quick payoff, but is it better than a 30-year mortgage? Some people would say yes. We’ll show you how to figure it out. In this installment of Prosperity Proofs, we’ll compare a “typical financial planning mortgage” to a mortgage in line with the Prosperity Economics Movement (PEM).

What is a “Financial Planning” Mortgage?

The 15-year mortgage:

  • Less cumulative* interest paid
  • Lower interest rate
  • Shorter time, higher payment, lower monthly savings
  • Any additional cash flow applied to the mortgage to build home equity
  • Some inflation benefit
  • Some interest deduction

Most of those bullet-points sound pretty nice, right? So why is a 15-year mortgage not necessarily the best choice? I’ll give you a hint: the third bullet point is key.

What is a “PEM” Mortgage?

The 30-year mortgage:

  • Typically less actual net compound** cost
  • Higher interest rate
  • Longer time, lower payment, higher monthly savings
  • Any additional cash flow applied to a “side fund” builds savings outside of the equity
  • More inflation benefit
  • More interest deduction

A 30-year mortgage is starting to sound pretty good, right? The thought of such a long payment period often holds clients back. Realistically, the 30-year mortgage offers more financial freedom.

Let’s look at the idea in action.

Comparing Mortgages

Mr. Client is buying a house for $250,000 and needs a loan of the same value. Fortunately, both a 15-year mortgage and a 30-year have the same interest rate of 4.5% at his bank of choice. If he goes with the faster repayment schedule, his monthly payments are about $1,912. The 30-year mortgage is a little easier on his wallet at $1,266 a month. But Mr. Client is hesitant to have debt that will take so long to pay off. And he’s going to have to pay more interest, right?

Choosing the right mortgage

To show Mr. Client a comparison, we’ve used the loan analysis calculator. Comparatively, it seems like the 30-year mortgage is going to cost Mr. Client a lot more in the long run. What the calculator doesn’t account for is the time value of money; or, opportunity cost.

The Cost of Cash

Say Mr. Client had the cash to pay for the house up front. In theory, he would save all of that interest payment. Mathematically, it’s true. What he misses out on, is the opportunity of putting those dollars to work somewhere else. Using our Future Value calculator, we’ll take a look:

Cost of paying cash

If Mr. Client had saved that same $250,000 over a 30-year period, at a rate of savings that matched his interest payment, he’d have almost $1 million. So although it cost him $250,000 up front, his long term opportunities have disappeared.

The Cost of Mortgage Payments

We can analyze that same cost on both the 30-year mortgage and the 15-year mortgage. If we plug in the monthly payments of each mortgage in the Future Value calculator, you’ll see the opportunity cost:

Cost of a 30-year mortgage Cost of a 15-year mortgage

 

 

 

 

 

The 15-year (180-month) mortgage still seems better!

What makes this comparison misleading is the fact that they aren’t compared over the same time-frame. If we apply the future value of Mr. Client’s payments at the same rate over another 180 months, we get this:

Opportunity Cost of 15-year Mortgage

The same exact number. Over that time frame, Mr. Client’s money paid in the first 15 years is still going to cost him the same dollars of opportunity.

So are any of these options better, if they all cost the same in the long run?

Revisit our “PEM Mortgage” list above, and you’ll start to see why it’s the better option. Lower monthly payments allow Mr. Client to save more right away. He doesn’t have to wait until his house is paid off to save. If opportunities pop up along the way, he’ll have an account to pull from to pay for them.

Saving the Difference

If Mr. Client uses a whole life insurance policy as a savings vehicle, his money can even grow at a higher rate than typical savings. And, when he wants to spring on an opportunity, he can borrow against his cash value without reducing what’s in his account. That way, his account will continue to grow!

Here’s what it would look like if Mr. Client has a 30-year mortgage and saves the difference at the same rate:

He would have accessible cash for the same value as the opportunity cost of 15-years of high payments. That’s a lot to digest.

And that inflation benefit? If we use a present value calculator, you can see that his very last payment will feel like $515 of today’s dollars. A 15-year mortgage won’t get inflation benefits quite like that.

So what are some of the 15-Year myths?

  • Equity increases the value of the house
  • More equity increases the owner’s financial strength and provides more control
  • Safer risk position from cash flow reduction issues (loss of job, disability, emergency)
  • Cumulative* interest paid is the cost of the mortgage

The reality is:

  • Higher equity reduces the loan balance but does not affect the value of the house which is determined solely by the market.
  • More equity causes less negotiating strength with the financial institution. To access the equity, you must sell the home or qualify for financing to borrow against it.
  • Extra equity can cause a loss of the property due to a reduction in the amount of available cash outside of the house for emergencies.
  • Total payments minus the tax deduction compounded** at a COM*** rate is a real cost.

With all of this to consider, a 30-mortgage seems like the right way to go. It keeps the client in control of their assets and their home. It provides the option to keep money where it’s liquid and accessible, not locked up in home equity.

Walk your clients through the Seven Principles for Prosperity, and choosing the right mortgage will be simple! The principles of the Prosperity Economics movement teach people how to think through everyday financial decisions. We’re preparing clients for success!

Advisors who are interested in learning more about the Prosperity Economics Movement, and how to take part, can visit Prosperity Economics Advisors. Clients can learn more at Prosperity Peaks.

Next, we’ll take a closer look at what sets Prosperity Economics apart from typical financial planning.

 

*cumulative: simple addition of all payments

**compounded: payments grown by an interest rate over time

***COM: cost of money. A personal earnings rate based upon a weighted average of savings or investment earnings and financing rates currently experienced (i.e. 4%)