September 20th, 2010 11:30 AM by Lehel S.
Zully Bravo, left, and Alfredo Gonzalez sit with a Bank of America negotiator as they try to restructure a mortgage loan during a Neighborhood Assistance Corporation of America's "Save the Dream" tour stop at the Palm Beach Convention Center in Palm Beach, Fla. (Joe Raedle, Getty Images / August 27, 2010)
Should you shorten the term of your mortgage?
Today's low rates have millions of homeowners rushing to refinance. However, a large number of mortgage owners in the U.S. are switching from the old industry standard of 30-year fixed-rate loans to those that must be paid off in 15 or 20 years, said Jeff Lazerson, president of the online brokerage Mortgage Grader.
Lazerson estimates that between 40% and 50% of his customers have been choosing shorter-term loans in recent months.
The shorter-term loans can save a half-percentage point in interest charges. And repaying sooner means you pay less interest over time.
The downside? You obligate yourself to a higher monthly payment. And even if you can afford that, there may be better ways to invest your cash.
"The long-term benefits of a shorter-term mortgage are real," said Keith Gumbinger, vice president of the consumer mortgage website HSH.com. "Is it the best use of your cash? That's going to depend."
Let's take a look at the options, using two hypothetical consumers — Suzie Secure and John Chance — who each need a $300,000 loan.
In today's market, they could secure 30-year fixed-rate mortgages at about 4.5% or 15-year loans at about 4%.
Suzie Secure chooses the lower-rate 15-year mortgage, which comes with a monthly payment of $2,219.
John Chance secures the 30-year loan, paying $1,520 a month — nearly $700 less than Secure.
Secure pays off her loan after 180 monthly payments, for a total cost of $399,420. Chance pays for 360 months, which brings his total cost to $547,223 — $147,792 more than Secure.
So is Secure better off? That depends on what Chance does with his monthly savings. If he invests that money regularly and is able to earn more than 4.5% in interest, he'd be comparatively better off.
Let's say, for example, that Chance invested in a diversified portfolio of big company stocks, which has earned an average of about 9.6% over the 83-year period tracked by Ibbotson Associates, a market research firm headquartered in Chicago.
Assuming he got that average return, Chance would end up with a nest egg worth $279,305 at the end of 15 years, but he'd still owe $198,701 on his mortgage. If he wanted to be debt-free like Secure, he could take that savings and pay off his loan, and still have more than $80,000 left in his investment portfolio.
Of course stock returns are anything but guaranteed, as the last "lost decade" so vividly illustrates. If Chance wanted to take a somewhat safer course, he could put the money in a portfolio made up of 50% stocks and 50% bonds, which has been considerably less volatile than portfolios made up of stocks alone. Historically, this investment mix produces long-term returns of 8.2%, according to Ibbotson. That would leave Chance with $246,216 at the end of 15 years — again considerably ahead of Secure.
What about taxes? Chance will pay less federal income tax over the life of his loan because he can write off mortgage interest — and he's paying more of it than Secure — but he'd owe tax on his investments when they are sold. For purposes of this example, we've assumed that this combination makes the tax issue a wash.
The catch is that stock market returns are not guaranteed. So where Chance might end up with a windfall, he also might end up with less. In today's market, there are no guaranteed investments that earn more than 4.5%.
That said, the odds of earning more than 4.5% on long-term money are in Chance's favor. There have only been a handful of 10-year periods when average stock market returns have been negative — two of them during the Great Depression and the rest during this last decade.
Investors have a tendency to believe that whatever happened most recently is most likely to happen in the future, but Ibbotson data refute that notion. If you look at decade-by-decade returns, bad decades were often followed by blockbuster decades; good decades — such as the 1980s and 1990s — were followed by this miserable decade, which was the worst in recorded history.
Though no one knows when markets might turn, the chance of stocks earning more than 4.5% on average over a long stretch is good, history tells us.
But, Gumbinger said, there's another risk. Namely, Chance might not be disciplined enough to invest his savings. If he's not, he ends up paying more with the longer-term loan and has nothing but depreciating consumer products to show for it.
"Too many of us, when we have an extra $100 bucks, say 'woo-hoo' and the next thing you know it's gone," Gumbinger said. "You've got to look at these questions in the context of your life when you decide the smartest thing to do."