Mortgage - good debt or bad?

This is an overly basic question, but my experience with these things is minimal.
I have been doing some research on a variety of topics and came across a video which was describing some advising to take out a shorter mortgage.
The video was against this, explaining a scenario like what I detail below in which a longer mortgage is the better investment.
I know there must be some in the community advocating both sides. From what I am seeing, the math speaks for itself - but I fully admit to maybe not seeing the whole pitcure.

(note these numbers are for example - just trying to understand the concepts)

- 200,000 mortgage loan

1) At 15 years and 2.0% interest rate I'll pay ~32K in interest over the life of the loan with a monthly payment of $1287

2) At 30 years and 3.0% interest rate I'll pay ~103K in interest over the life of the loan with a monthly payment of $843

$1287-843 = $444 savings / month over the life of the loan with 30 year.

If I invest this $444 with a 7% annual return over the course of 15 years I will make $139K.

So - I paid $71K in additional interest over the life of the 30 year loan, but I gained $139K from saving $444 a month for 15 years. A net profit (seemingly) of $68K.

(Additionally I believe that I am saving more in taxes annually because I am paying more in interest.)

The math seems to speak for itself, So what am I missing in this scenario? The only variable # here is my 7% return - which I think is conservative estimate for the market over 15 years, no?

Am I overlooking something incredibly obvious to make the 15 year the better option? I know plenty of people prefer to get out of debt as soon as possible - but this seems to me like controlled debt - as you are actually calculating the payoff (which appears to be greater by extending the life of the loan).

I'm sure right now many of you are saying "no $hit sherlock - obviously the 30 year is the smart way" and others might be saying "dumb a$$ - you aren't figuring x,y, or z"

I'd like to understand the latter's view as to why this *isn't* a good idea.

If you KNOW you'll earn more than the mortgage rate on your investments, then a long mortgage is better. 7% is probably a reasonable estimate for long term returns these days. It is more risky to invest instead of paying down debt (although it can pay off more when investments do well).

I assume 7% from the stock market. I believe that most people say the returns are around 7-10% on average over long term investment. My experience through my managed investments over the last few years is closer to twice this number.

Regarding your math of the investments for years 16-30, I think I figured out a more accurate representation of the math above:

30 year mortgage I invest $444/mo for 30 years (7%) = $523K
15 year mortgage I invest $1287/mo for 15 years (7%) = $404K
Difference of 119K more earnings with the 30 year. I paid 71K more interest though so net difference is still 48K.

Based on the calculator I found here it also appears I will save close to $20K more in tax deductions over the course of the 30 year, bringing the net closer to 68K (possibly more when able to also invest the additional money saved from taxes).

tjguitar85 said:   Well of course if you assume 7% return then it's a good idea, because you are only paying 3% interest. What conservative investment do you have that pays 7%? I wouldn't want to leverage my home in risky assets, unless I had incredibly stable income to afford the possible losses.

My savings account pays 1%. CD's don't pay much more than that.

The 15 year loan will let you allot $1287/mo to investments for years 16-30, around $230,000.


To me, it just doesn't make sense to borrow at 3% and lend at 0.6%....If you assume that the rates will go up a lot during the duration, then you probably come out ahead....but people have been saying that rates will go up for five years.

So this *may* be a great point I missed - the fact that you won't keep the house/mortgage for 30 years.
I'm not entirely sure how to do the math on this - but using the numbers above:

If I took out the 30 year and left after 10 years I will have paid ~53K in interest
If I took out the 15 year and left after 10 years I will have paid ~28K in interest
So I paid 25K more in interest. However, during that time I invested the $444 I saved each month and after 10 years at 7% I get ~77K, for a $52K net.
There may be a point early on where you come out below, but wouldn't it still work out better even in this scenario?
Even if I didn't invest that 444 a month that is still 53K over the course of 10 years that still has me coming out ahead in my savings over the interest, no?

I admit that 7% is speculation - and I am not that well versed in finance. I learned what little I know mostly from my father who like me now, puts a large portion of assets in the market. Based on his performance over the past 40+ years, and the return on my investments I would say 7% was a conservative number.

atikovi said:   You got to remember that few people keep a 30 year mortgage for 30 years and it's those last few years when your payments are mostly for principal. For the first 20 years your payments are mostly for interest so you don't build up much equity. Sure you get a tax deduction but paying $1,000 in interest for the privilege of a $300 tax deduction is stupid. And getting a 7% return in your lifetime is just speculation. It could be 20 years before we see CD's over 5% again.

I dont know if this will format right but when I calculate it (at 3% and 4% interest rates) at the end of 15 years you have either a paid off house, 200K net or owe 123K with 83K in the bank. Where my calculations differ is, I then take the entire amount of the 30yr mortgage and dump it into the market and at the end of 30 years, you have 308K in the bank with a 15 yr mortgage and 241K with a 30 yr. I did a flat yearly interest instead of compounding.

Edit: removed excel dump because it wasnt readable.

atikovi said:   And getting a 7% return in your lifetime is just speculation. It could be 20 years before we see CD's over 5% again.

mikef07 disagrees with you.

A lot of discussion related to this topic has been covered here:

http://www.fatwallet.com/forums/finance/426039/

BenH said:   Based on his performance over the past 40+ years, and the return on my investments I would say 7% was a conservative number.

Ahh, the falicy of relying on past trends to predict the future. Did anyone 40 years ago think we would see sub 1% savings rates now?

BenH said:   
1) At 15 years and 2.0% interest rate I'll pay ~32K in interest over the life of the loan with a monthly payment of $1287
2) At 30 years and 3.0% interest rate I'll pay ~103K in interest over the life of the loan with a monthly payment of $843

Obviously, this is a pretty complex calculation and question with a lot of variables that exist in the long term that are difficult to pin down. But, one thing I wanted to point out: Lots of people know that the 15 year will result in less interest payments, and that's all they think about, and lock into those. But, as you're seeing, there's a lot more involved. Another benefit of the 30 year is simply the lower payment. Sure, you can probably make the 15 year payment, or you wouldn't be looking at it, but what about when things get tight. Which payment will be easier to make when things go downhill? So, that extra interest is also buying you some rainy day insurance against a high monthly payment. The opportunity costs, which you are trying to calculate, can be pretty massive too, especially if you hold the loans for the duration.

BenH said:    Mortgage - good debt or bad?From a pure investment return standpoint, if you have a reasonable expectation of being able to generate a return that exceeds your cost of funds, it is good debt. Do all the math you want, but in my book, the only calculation I need to do is 7% > 3.5%.

adamsmart78 said:   First 15 years: your payment 843 vs other guy's 1287-===> you make 7% on the difference of $444

16-30 years: your payment 843 vs other guy 0 (zero) ===> other guy makes 7% on the difference of $843

You left out some very important data. 16-30 years, you continue to make 7% on all the returns from years 1-15. In other words, compound interest.

dcwilbur said:   BenH said:    Mortgage - good debt or bad?From a pure investment return standpoint, if you have a reasonable expectation of being able to generate a return that exceeds your cost of funds, it is good debt. Do all the math you want, but in my book, the only calculation I need to do is 7% > 3.5%.
That is true as long as OP also keeps in mind the associated risk with the 7% return (not guaranteed).

OP: Here is a hypothetical situation. You have two job offers. One is say from the Federal govt. (read as stable and guaranteed as it gets). Pays 50k.

The other is from say a small company; has been there for a while but sales/revenue/profit can be quite unpredictable. They offer you a base salary of 25k plus added bonus depending on company performance. Based on past company performance, your bonus would "on average" be 35k. But it can be as low as 0 or as high as 75k. Indeed, there have been several year stretches in the past when company has done poorly to net you 0 bonus. But company has also done well several years when your bonus would have been 75k. Of course past company performance is no guarantee of what happens in future.

Which offer would you go with?

P.S. I understand, considerations of risk are different for your job vs. investments. But hopefully you get the gist.

OP, the proper method to compare the two mortgages is to calculate the net present value of the cash flows. The big variable there being the discount rate used. This is because the value of the USD loses value over time, and the final payments you make on a 30 year mortgage will be worth a fraction of what it is worth today.

Excel is your friend.

To calculate the payments for the two loans you use
=PMT(0.03/12,360,200000,0)
and
=PMT(0.02/12,180,200000,0)

Then to determine the NPV of all the cashflows with a 4% discount rate, you use
=PV(0.04/12,360,A1) $176,619.41
=PV(0.04/12,180,B1) $173,994.65

A1 and B1 represent the monthly payment amount. You divide by 12 to convert the annual interest rate into monthly. For a more accurate answer you can divide by 365 to compute daily interest.

So at a 4% discount rate the loans are roughly equal. The key here is what discount rate rate you use... but that's not a discussion I'm going to get into. The 30 year mortgage is a much better deal particularly because the interest is tax deductible and inflation will eat away that payment over time.

Best of luck.

brettdoyle said:   OP, the proper method to compare the two mortgages is to calculate the net present value...No offense, but you've really over-complicated the analysis, AND you completely ignored what the investor does with the difference between the two payments.

tjguitar85 said:   Well of course if you assume 7% return then it's a good idea, because you are only paying 3% interest. What conservative investment do you have that pays 7%? I wouldn't want to leverage my home in risky assets, unless I had incredibly stable income to afford the possible losses.

My savings account pays 1%. CD's don't pay much more than that.

The 15 year loan will let you allot $1287/mo to investments for years 16-30, around $230,000.


To me, it just doesn't make sense to borrow at 3% and lend at 0.6%....If you assume that the rates will go up a lot during the duration, then you probably come out ahead....but people have been saying that rates will go up for five years.

tjguitar85's response is the only valid response. Of course you are better off taking a longer (or bigger) loan if you can make more than your interest on the loan, this is a no brainer. The only problem is you are not guaranteed to do this.

You said, "My experience through my managed investments over the last few years is closer to twice this number."
Last few years meaning after the market crash? Well, that is easy enough... but how about if you had started investing in 2005-2007? Would you have kept investing the $444/month as your stock values plummeted 50%? If you had the balls to buy on the dips then eventually you would have turned a good profit, but there was HUGE risk in stocks during those time (and even now).

So... it all comes down to one thing: if you think you can beet the 3% interest rate on your mortgage, then YES you should take out a longer/bigger loan and invest. BUT, if you want guaranteed savings (and less risk), then take out a shorter/smaller loan. Simple as that (except its not really).

I have few more points for you to consider in calculations.

1) Factor in tax savings for paying higher interest in first scenario and also additional tax burden for interest income on second scenario.

2) Like others said, getting consistent 7% return on debt instruments may be not always available, but on long 15+ years, may be it is possible to invest in funds and gain that.
Still have to worry about taxes....

3) Some people may not be able to handle additional burden on a Consistent basis of paying higher monthly payments (15year vs 30).
I have read and heard from few friends who say paying 13-14 payments is more reasonable than assuming for next 15 years always able to pay higher payment.

dcwilbur said:   brettdoyle said:   OP, the proper method to compare the two mortgages is to calculate the net present value...No offense, but you've really over-complicated the analysis, AND you completely ignored what the investor does with the difference between the two payments.

That's the whole purpose of the discount rate.

The answer is that it depends. Having liquid cash is a service that there's a cost attached to. It's up to you to decide if that cost is worth it to you.

brettdoyle said:   dcwilbur said:   brettdoyle said:   OP, the proper method to compare the two mortgages is to calculate the net present value...No offense, but you've really over-complicated the analysis, AND you completely ignored what the investor does with the difference between the two payments.That's the whole purpose of the discount rate.Okay, I'm not going to get out the textbooks, but you wouldn't use the same discount rate for a 15 year cash flow as you would for a 30 year cash flow, now would you?

BudmanTom said:   The $71k savings is a sure thing and investments are speculation, you have to weigh the possibility in not only not making money but losing it.

Nothing is a sure thing looking into the future.

Except if everything around you REALLY goes poof, your house will only be a haven if you can defend it. And if you were equipped to defend a paid off house, you'd also be equipped to go take what you wanted from people who were not equipped to defend their property. (Just finished catching up on Revolution episodes so this comment has a bit of a survival bent).