What's wrong with a 15-year fixed rate mortgage? Plenty

With mortgage rates hovering around record lows, the mortgage refinancing business is booming.

The days of pay-option NINJA (No income, no job/assets) loans are over, and fixed rate mortgages are cool again. The New York Times reports that the ultimate conservative financing method -- the 15-year fixed rate mortgage -- is gaining on the 30-year mortgage.

But is that too conservative? I think so. In fact, I'll go out on a limb and say that with interest rates this low and the specter of inflation as strong as it is, you would have to be nuts to take out anything other than 30-year fixed rate mortgage right now.

Here's why: A 15-year fixed rate mortgage achieves very little savings compared with a 30-year mortgage, but lacks any of the flexibility. Let's look at it with numbers (courtesy of BankRate.com):
  • The interest rate on a 30-year fixed rate mortgage is 4.98%. The monthly payment on a $200,000 loan is $1,071.20.
  • The interest rate on a 15-year fixed rate mortgage is 4.63%. The monthly payment on a $200,000 loan is $1,543.31.

Of course the advantage to the 15-year loan is that you only have to make the payments for half as long. On the 30-year loan, you'll spend at a total of $385,632 compared with $277,795.80 for the 15-year loan. That "savings of $107,836.20" is what sells most people on the 15-year mortgage.

But when you look at it more closely, it falls apart, and here's why: Most of that savings comes from paying the mortgage off in 15 years instead of 30 (You can pay off a 30-year mortgage in 15 years if you want to), not from the lower interest rate. All other things being equal, paying off a mortgage in 15 years at 4.63% vs. paying it off in 15 years at 4.98% only saves you a whopping $36.19 per month.

But by committing to a 15-year mortgage instead of a 30-year mortgage (with the option of making extra payments), you give up flexibility: What if interest rates rise and you can invest in Treasury Bills that yield 10%? You will have screwed yourself out of a lot of money by plowing that extra $472.11 into your house to avoid paying 4.98% interest on it.

Worse, plowing that extra money into your house is a good way to end up house poor -- tons of home equity but little in the way of other assets -- which can lead to disaster if you need cash at a time when interest rates are high.

Let's say that mortgage rates are at 11% in five years (stranger things have happened following debt-fueled federal spending binges) and you decide that you want to take out a home equity loan to help your kids pay for college. You have a lot of equity built up in the house -- you only have 10 years left on the mortgage -- but you have a problem: Even though the interest rate on your mortgage is 4.63%, borrowing against the value of your home would require you to pay an interest rate of 11%, and you can't afford those payments.

If you'd taken out the 30-year mortgage and saved the extra $500 per month, you'd have plenty of cash to pay for college and wouldn't need to take out a loan. But you didn't so now you have three options: 1.) Find another way to pay for college. 2.) Tell your kid to go to a cheaper college. 3.) Sell the house to unlock the equity, even though you really don't want to.

And all that to save a lousy $36.19 per month -- even though it's actually less than that if you take a tax deduction for the mortgage interest. It just doesn't make any sense at all.

The bottom line is that the 30-year fixed rate mortgage offers you tremendous flexibility and with rates as low as they are right now and long-term inflation likely to ensue, I think you would have to be crazy not to lock in the right to borrow money at 4.98% for as long as you possibly can.

And if I'm wrong and rates head down to 3% (I will bet anything that that doesn't happen!), you can refinance!
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