Wiping Out the Mortgage
You and your friends have stumbled upon one of those nebulous questions that can keep financial-planner types in heated discussions through the wee hours of the morning. Fact is, there really isn't a right or wrong answer here. And just which side of the argument you fall on depends on your own particular financial situation, including your attitude toward debt and your confidence in your investing abilities.
That said, from a pure number-crunching perspective, your argument is clearly right. After all, mortgage debt is cheap debt, especially these days, when the average 30-year fixed mortgage is a mere 7.04%, according to HSH Associates, a mortgage-tracking firm. Add in the tax deduction on the interest, and we're talking dirt cheap. Consider that if you're in the 30.5% tax bracket, that 7.04% rate is roughly 4.9% after the interest deduction. And while earning more than 5% in the stock market might seem like a pipe dream these days, history tells a different story. With large-cap stocks returning, on average, 10.5% annualized from 1926 to 2000, according to the Center for Research in Security Prices, it's certainly reasonable to think that you'll get more bang from your buck by keeping your mortgage and investing your savings instead.
But in real life, personal finances are rarely managed in textbook fashion. And the fact is, in this environment — where people are worried about their jobs as well as their portfolios — getting out from under the yoke of debt can have real appeal, says certified financial planner Dee Lee of Harvard, Mass., particularly for those nearing retirement. It's also a prudent move if you're the type who will take that extra money you intend to "invest in the market," and choose instead to invest it in, say, some Louis Vuitton luggage or the new Lexus SC 430. "American consumers aren't exactly the most diligent of savers," observes Keith Gumbinger, vice president of HSH Associates. And paying down your mortgage is a form of forced savings.
For most folks, however, compromise is probably the best answer. As you mention, one way to do this is to take a 15-year vs. a 30-year fixed loan, since it allows you to reduce your debt relatively quickly while also building equity in your home much more rapidly. If, for example, you had a $250,000 mortgage financed at 7%, you'd pay a whopping $348,772 in interest over the lifetime of the loan. Over 15 years? That would be $148,209. Another advantage: If you end up staying in your house for only five to seven years, as most folks do, you'll come out with much more equity in your home, Gumbinger explains. Using this same example, if you wanted to move after seven years in the home, you'd still owe $227,868 of your principal with a 30-year loan, vs. $163,755 with one financed over 15 years. But the trade-off for all of this is that your monthly payments would obviously be much higher — $1,663 vs. $2,212 in this case.
But unless you've got gobs of money as a security blanket, you're probably better off going with a 30-year loan but treating it as if it's a 15-year loan, says Neill Fendly, the former president of the National Association of Mortgage Brokers. In other words, just prepay your mortgage, something nearly all lenders allow. By prepaying your mortgage — even if you only make one extra payment per year — you can pay down a 30-year mortgage in 23 years. (Just make sure you aren't charged a fee for doing so.) This way, you have the option, rather than the requirement, of paying down your loan rapidly. So if life throws you an unexpected curve ball — such as if you lose your job or suddenly discover that you're having triplets — you can just revert to the smaller payments, says Lee.
Of course, it pretty much goes without saying that paying down your mortgage should come into play only after you've covered some more basic personal-finance bases. This includes paying off credit-card debt or car loans, as well as maxing-out your retirement plans. Assuming you've got all that covered, though, click here to run your numbers through our mortgage-prepayment calculator.