Most people who buy a home don’t have much of a choice when it comes to choosing between a 15 year versus 30 year mortgage. With a median household income of $55,775 in the US and stringent underwriting, most Americans can only afford to pay over a longer term. Physicians, on the other hand, have much higher incomes and more flexible underwriting with physician loans. Having the option to choose between a 15 year versus 30 year mortgage, you need to ask yourself if it’s right for you. The truth is that it may or may not be depending on your situation. To help you weigh your options, I’ve created this calculator so you can use the numbers applicable to you.
To determine how much home you can afford, you want to start with the debt to income ratio. Generally, the debt to income ratio is limited to around 28% of gross income. If you have an income of $200,000, then you can use $56,000 (28% of $200k) of it to pay towards PITI (principal, interest, tax, insurance). Next, you need to consider the down payment. As a physician, you can usually utilize a “physician loan” that allows you to finance up to 100% of the purchase without incurring PMI (private mortgage insurance). Lenders are willing to do this because physicians have very low default rates. Let’s say you opt for a 10% down payment. This means you can afford to purchase either a $738,000 home with a 15 year mortgage or a $1,074,000 home with a 30 year mortgage.
Depending on the area you will be purchasing, $738,000 will buy you a lot of home. However, if you have you sites set on a home priced greater than that, you’ll either have to increase your down payment or be forced to utilize a 30 year mortgage. In which case, there would no longer be an evaluation to be made.
Low-Interest Rates and High Investment Returns
At this point, I’m going to assume that your maximum purchase price falls within the debt to income ratio for a 15 year mortgage so that you have the option. There’s no doubt that when you ask around about choosing between a 15 year versus 30 year mortgage, you’ll hear about how you should take advantage of the current low-interest rates by opting for a 30 year mortgage and investing the difference. It’s not a bad argument. It makes sense to allocate your wealth into assets that will work hardest for you.
So let’s take a look at the numbers and see how it shakes out. I’m going to continue with the previous example of $200,000 gross income and a 10% down payment. As I write, interest rates are currently 3.25% for a 15 year mortgage and 4.09% for a 30 year mortgage. I’m also going to assume using a balanced portfolio to invest the difference in. As a proxy, I’ll use the Vanguard CRSP 60/40 (equities/bonds). This portfolio has an annualized return of 6.16% in the past five years. Of course, past performance doesn’t guarantee future returns.
With a maximum purchase price of $738,000 and a 10% down payment, you would be financing $664,000 and paying $56,000 per year on a 15 year mortgage. However, if you opted for a 30 year mortgage instead, your annual payment would be $38,500. The difference of $17,500 would be invested. For the sake of comparison, we’ll also assume that on a 15 year mortgage, the same cash flow of $56,000 per year will continue for 30 years, but since the mortgage will be paid off in 15 years, the cash flow is invested for years 16 through 30.
The way that these assumptions play out is interesting because the end result isn’t that much different. The cash flows over 30 years are exactly the same, $56,000. Interest paid on the 15 year strategy is $314,000 less, but the investment gains on the 30 year strategy are $427,000 more. In the end, both strategies end up with a free and clear home and an investment portfolio of either $1.4 or $1.5 million.
Because this strategy is designed to capitalize on the difference between interest rates and investment returns, let’s say I invested aggressively at 100% equities. Using the Vanguard CRSP 100% equities portfolio (9.76% return), we now end up with a significantly different result in investment gains. Using this new assumption, the investment account from the 15 year strategy ends up at $1.9 million and the 30 year strategy ends with $3.0 million. Sounds amazing right? Ideally, yes, but the problem with this is that investing in equities brings no guarantees. Your performance results may not be as good as they have historically shown. This may be a result of poor market performance or your own behavior. However, choosing a 15 year mortgage does guarantee a return in the form of savings.
Choosing a 15 Year Versus 30 Year Mortgage in Real Life
While the previous example makes perfect sense “on paper”, it may not be that realistic. There are outside forces that could derail you from investing the difference between payments of a 15 and 30 year mortgage. If you do decide to go for the 30 year strategy, I’d highly recommend setting up a systematic withdrawal that automatically debits your checking account on a regular basis and invests in a model portfolio. Once that’s set up, leave it alone and let it do its thing.
For younger physicians with high student loan debt, this may not be a viable strategy. Between loans and saving in a pre-tax retirement account, especially when an employer match is in play, you may not have enough cash flow to even opt for a 15 year mortgage in the first place.
With all these considerations to weigh out, it can be a tough call in choosing between a 15 year versus 30 year mortgage. This is, however, not going to be a decision that will make or break you financially, so don’t stress out too much about it. If you’re disciplined in investing the difference and can tolerate market volatility of investing in mostly equities, this is likely to be a good strategy for you. If you’re lured by the siren call of the latest gadgets or a slick new BMW, maybe it’s better that you commit yourself to the higher payment of a 15 year loan. Be honest with yourself and do what you think is best for you.
So what do you think? Which sounds better for you? Paying off your mortgage quicker for the guaranteed savings and peace of mind, or paying it off slowly and investing the difference?