April 29, 2020
My Dear Reader,
While the government is still attempting to keep us locked under quarantine, I thought it would be interesting to look at common misconceptions in the financial field. One of the lynch pins in the debt pay-down theory is to pay off all debt as quickly as possible. One of the ways this is accomplished is by choosing a 15 year mortgage over a 30 year mortgage, this Forbes article, written in 2016, lays out the 3 main reasons why a 15 year mortgage is sold over a 30 year.
“1. Save more money 2. Build more equity 3. Reduce pressure on your monthly budget in retirement”
So I’ve decided to take the next three articles on KevinPrendiville.com and use them to examine and counter each of these three main points presented. The first is “saving more money”.
One of the essential financial principles we have discussed is opportunity cost. When a home is bought with cash or paid off in the shortest amount of time, the lost opportunity cost can be astounding. For instance, let’s take two brothers, Orville and Wilbur, who both think they are in the right. Each brother is going to buy a $500,000 home in Florida. Orville decides to get a fifteen year mortgage [FIG 1], so he can pay off his home faster and then invest the money that he would have been spending on his mortgage. His brother Wilbur decides to get a thirty year mortgage [FIG 2] and invest the difference that he saves per year over Orville. To make it simple, both have a $500,000 loan with a flat 5 percent interest rate. Orville will pay $3,953 to the bank every month and Wilbur will pay $2,684. If we assume there were no market crashes at all and both earned the current average rate of return at 7.91 percent Orville will make $1.3 million in the fifteen years after paying off his house. Not a bad sum.
FIG 1 FIG 2
His brother Wilbur will invest $1,269 every month, as this is the difference between the brothers’ interest payments. Wilbur will have made $1.8 million by the time his house is paid off. Put simply, it’s because Wilbur has a fifteen year head start on his brother, and the better the market does, the larger the gap becomes. Now that we understand the financial principles laid out at the beginning, does it make sense to get a short term mortgage? You have more flexibility, more opportunity, and you’re not throwing money into a structure from which you can barely retrieve it. Though it may look like you’re saving more money on paper, in reality, the picture is much more detailed.
To your creation and potential,