It’s the Principal of the Thing

In a good sign for the economy, the Baby Boom generation is gradually switching from consumption to saving. Spending begins to give way to saving in any 35-44 age group, and the average Boomer is just now turning 42. Leading edge Boomers (one is turning 50 every seven seconds) are near the panic saving stage.

However, some popular vehicles for savings are poor ideas, and a leader in the bad deal category is the 15-year mortgage. The sales pitch is often irresistible: interest savings, free and clear ownership, and equity buildup.

“Look at all the interest I can save — that’s not a ‘sales pitch’!”

No, it’s not; it’s a half pitch. The missing half includes news that the interest savings aren’t worth as much as you think, and you have to give up investment earnings worth more than the savings.

The half pitch standard example goes like this: the total interest paid over thirty years on an 8.50%, $100,000 loan is $176,808; on the same $100,000 for 15 years at 8.25%, the total interest is only $74,625.

A $970 payment instead of $770 — an extra $200 each month — and you save a hundred grand in interest.

“What’s wrong with that?”

The missing half of the pitch.

If you add up all the interest paid over the life of a loan, you assume a dollar paid 30 years from now is worth the same as one paid today. Today’s dollar is worth less than one fifth its value 30 years ago: under reasonable inflation assumptions, the astronomical interest “savings” in the 15-year pitch shrink by half or more.

Worse, the half pitch treats these interest savings in isolation, as though you had no other use for two hundred bucks each month for thirty years. “Opportunity cost” analysis asks the question, “what else could I do with my money?” What would happen if I saved the extra $200 each month, instead of sending it in to the lender? Which would bring me the greater return?

If you pay your lender back early, you save the after tax cost of the interest. Mortgage interest is deductible, and assuming a 33% total bracket (28% federal and 5% Colorado), only two-thirds of your interest payments are “real.” The same is true for rate: two-thirds of 8.50% is a 5.70% after tax cost.

If your after tax savings pay more than 5.70%, feed $200 each month into savings. If your long term savings earn less than 5.70%, don’t send $200 each month to your lender; shoot your financial planner.

You can’t earn 5.70% after taxes at a bank, but a conservative pool of mutual funds will earn nearly double that rate over time. You’ll do ‘way better with any tax-deferred account for which you are eligible: IRA, 401K, 403B, Keough, ESOP, PERA, or TIAA. There may not be a 401K in Boulder County which has failed to compound at 10% in the last couple of decades.

“But I want to own my home free and clear!”

Not really. Houses make good investments, but modest leverage puts them in the “great” category. For example, if you own a $100,000 house free and clear, and its value rises $10,000, you have a 10% return on equity. If you had a $50,000 mortgage on the same house, and the same $10,000 appreciation, your return on equity would be 20%.

“But I don’t want to have a house payment when I retire!”

Okay, if you have diligently saved and managed your $200 each month until retirement, you’ll likely have a much larger pile of a savings socked away than the mortgage balance. If you want to pay it off, go ahead. Of course, if it turns out later that you need some cash, you’ll wish you had kept your own instead of having to argue with a banker to get it back.

“But the lender told me a 15-year loan would build up equity so fast.”

My favorite fib. If you have $200 in the bank, and send it in to your lender, your loan balance will fall by $200, and so will your bank balance. Your net worth increases by… nothing. You have shuffled your balance sheet, but the hand you hold is the same.

There are borrowers who really could benefit from a 15-year loan. People who are afraig adjustment at the end. Bythen you will probably have refinanced anyway. The high caps allow the lender to make up for a big mistake inthe first five years; in return, the lender gives you a cheaper first five than tight caps would allow.

Trade away the periodic cap for a low life cap. You can still find ARMs with a life cap in the elevens if you’llshoot craps from year to year.

It is very desirable and very expensive to buy down the margin. Margin is a big deal because it’s a fixed cost ineach adjustment. Breakeven for buydown tends to be three and a half years — when it’s allowed.

Keep your intentions clear about how long you will own the house, how long it may be until the next refinancingwindow, and what the Fed is up to. Don’t ever be tempted into an ARM at a bottom in rates, or frightened awayat the best time- at a high in rates, or rising into one.