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Thirty Year Thinking
It's only twenty-eight bucks a month, but over thirty years it's a lot of money.
"If I pay it off in fifteen years, think of all the money I save compared toÉ"
Most consumers have a tough time comparing long term financial products, and it's not their fault.
For one, people selling financial products have an incentive to confuse clients. The products are all about the same, and all sell for about the same price -- it's just money, after all. If a salesperson can get a client 'way off in dark mathematic woods, and then take away the trail of breadcrumbs, it's possible to make the same products and prices look different.
It's possible to get an advanced degree from a fine university, even a technical degree, and never be exposed to money math. Money math is generally referred to as the "time value of money", which governs miracles like compound interest, the present worth of money to be paid in the future, and losses from inflation over time. A branch of money math involves an analytical concept called "opportunity cost."
"Present worth" is the magic decoder. When trying to figure out the cost of an extra $28 per month on a 30-year loan, most folks want to multiply $28 times 12 months each year times 30 years, which equals $10,080, which is a lot of money. However, at five percent infaltion per year, the last $28 in the 360th month is worth only $6.48 in today's dollars, the total cost accordingly lower.
Fans of 15-year loans like to compare "extra" interest costs. For example a $150,000 30-year loan at 7.75% costs $1075 per month, and a total of $387,000 over its life. A 15-year loan at 7.375% costs $1380 each month, but only $248,400 over its life for a "savings" of $138,600.
Such "analysis" not only ignores inflation (at five percent, the last 30-year, $1075 payment costs $240), but commits the capital crime of treating early principal repayment as free money. Opportunity cost thinking assumes the repayment money has a cost.
You could have invested it, instead. If your mortgage costs 7.75% before taxes, it probably costs less than 5.20% after taxes. Any investment you can make which will earn more than 5.20% after taxes is a better use of your money than paying off your mortgage early. (If you have a hard time with after tax cost, or investments yielding more than 5.20%, call your CPA, or see "Financial Planning Consultants" in the Yellow Pages.)
Instead of taking a finance course, or spending a few months playing with the "NPV" (net present value) function on a spreadsheet program, here are some non-thirty year rules helpful in dealing with mortgages.
1. Think about how long you will live in the house, and compute points and fees to that breakeven point.
2. Think about how long you will have the loan. If you get a loan in a high rate, or even middle rate environment, you are very likely to refinance within only a couple of years. Or refinance to go from ARM to fixed rate, to send a kid to college, to add on to the houseÉ.
3. Remember that lenders assume that the average 30-year loans lasts only seven years, 15-year loans about five and a half, and ARMs from three to four years. If your loan-holding period is longer or shorter, you can use lenders' assumptions against them.
4. Figure an "investment cost" for any dollar of down payment less than 20% or more than 20% (one introduces mortgage insurance cost, the other costs too much in lost investment return).
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