15
Year or 30 Year Loan? - Which is better, smarter, or
truly less costly?
The
answer is not a simple one yet it's worth taking the time to understand this
as the results may surprise you
Loan Amount =
30
Year Fixed Rate Loan
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15
Principal & Interest
Payment @
15
Year Fixed Rate Loan
Principal & Interest
Payment @
A 15 year loan has a lower
rate, yet higher payment than a 30. This is fine if you're capable of
handling the difference, yet the true comparison lies in the other things you
might do with that cash
Payment
Savings of 30 vs. 15
Total
Payments Made - this is the year by year total accumulated payments on each
option
Total
paid on 30
Total
paid on 15
The
perceived benefit of a 15 year loan is in the rapid payment of principal. In
15 years, you've paid back the entire loan
vs. the 30 where you're half way time wise but have paid only a third
of the balance
Principal
paid on 30
Principal
paid on 15
Remaining
Balances - this is the total remaining principal balance of each loan for
each year
Remaining
balance on 30 year loan
Remaining
balance on 15 year loan
Extra
balance remaining on 30 year loan
This
is where most "conventional" analysis stops. Why would anyone that
can afford it want a 30 year loan when they could have a lower rate and a
shorter term with the 15? Good question, let's take a look:
Reason number 1 - Flexibility. The
opportunity value of the lower monthly payment on a 30 year loan can be worth
more than the benefit of a lower balance. Imagine if you lost your income,
would you
survive
longer on your savings or emergency reserves with a higher or a lower
payment? Let's first just take the payment savings and add it up year by
year.
Total
Payment Savings
So it's not
just flexibility but safety. The accumulated savings as you see above can go
a long way towards subsidizing your living expenses in the event of job loss,
disability, other medical emergency, large
unexpected
expense, etc.
If
we look at the "extra balance remaining on a 30" from above, but
now subtract from it the value of our accumulated savings, we see how much
smaller the real difference has become:
Extra
balance on 30 - accumulated savings =
Now,
let's take it another step further
For those
that can afford a 15 year term, you are typically also in a higher tax
bracket and as such, can derive a greater deduction on the interest that you
pay. Since the rate on a thirty year loan is higher
and since you're paying interest on a higher
remaining balance, so too will your total tax deductibility be higher.
Here,
we'll look at total interest paid and the resultant deduction at your
marginal tax bracket
Total
interest paid on 30 year loan
Total
interest paid on 15 years loan
Marginal Tax
Bracket =
Total
Tax Deduction on 30 year loan
Total
Tax Deduction on 15 year loan
Extra
tax savings on 30 year loan
The
Bottom Line
Total
of tax and payment savings =
Further
to this point, one would hope that you're not just stuffing the money in a
shoebox. Placed in an interest bearing or investment account, the total
accumulation grows even higher:
Savings earning interest @
The effective final
difference of a 30 vs. 15
When the
numbers above turn negative, that evidences that the 30 year loan is actually
less expensive than the 15 - hard for some to believe, but it's really just
math, the benefit of tax deductibility and
the magic of
compound interest. I will of course be happy to walk you through how all of
this works and to explore with you what the best options are for your
preferences, peace of mind and suitability.
To make this
visual, we'll use a graph and indicate the 15 year loan as the baseline
(zero). We'll then impose the real cost difference of the 30 against it. The
point at which you may cross under the zero
baseline is
the point at which the 30 becomes more advantageous than the 15. This will
vary with the interest differential, the investment rate and your tax bracket
and as such, may evidence the 15 year
as being the
less costly option.
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The end
result here is that it's not as cut and dry as you may have imagined. If you
value the benefit of having a liquid emergency account or greater accumulated
savings and investment capital then
using a 30
year loan strategically (meaning not just blowing the savings but putting it
to work) can work out better in the long run both financially and even for
peace of mind. It's counter-intuitive that a longer
loan and a
higher interest rate could ever work to your advantage yet if you're willing
to take the time to understand and do the math, then you begin to realize
that conventional thinking can be flawed.
