Simple case where a 15yr mortgage is better than 30yr

[Assaf Furman]

In a recent article, @Scott Trench discussed the advantages of a 30 year note over 15 year (or lower than 30 in general). While I agree with most of what's there, I'd like to discuss a case where to me at least, it seems that a 15yr note is far better:

Let's take Jerry - a 30 year old employee, loves his job and has a positive outlook for his future in the industry. His goal is to accumulate enough equity so that he would have the option to retire in his 50's. Like many, he doesn't understand nor trust the stock market as a reliable source for passive income and wealth building, so he would rather direct his savings towards purchasing rental properties one at a time. Since he wants to gain equity rather than produce cashflow, he needs to structure the deals so that in the end he would pay the least amount for the properties plus have free and clear rentals that produce the maximum cashflow for the retirement period. 

Here comes the fun part of doing the math. For the sake of simplicity I took easy numbers to work with which meant to compare the two options - you can and should do the whole calculation yourselves with numbers that work for you.

The average price for a rental property that worked for Jerry is $100k, and every year he saved up $20k to buy a property*. After 10 years he finished buying, and started using the residual income to pay down the loan of the first property so that it clears of debt faster. Then he moves on to paying the second and so on.

Option 1: 15yr mortgage at 2.625%** comes down to a total of $96,867 with monthly payments of $538/mo

Option 2: 30yr mortgage at 3.5%** comes down to a total of $129,325 with monthly payments of $359/mo

When I use these assumptions to calculate which option works better for that particular scenario, the 15yr loan wins big time. For example, the total difference in the mortgage payment is $324,580 which is a lot of money to gain (or lose) just by strategizing properly. Also, by the time Jerry celebrates 55 he has at least $1MM in the shape of 10 properties, that add $5380 more to his monthly income. In fact, he began adding that sum even earlier since he was able to pay down the loans faster using his salary and any leftovers from the rent. That couldn't have happened with a 30yr mortgage. Even with less properties, different prices or whatnot - as long as the rent covers the total expenses that would result in a faster accumulation of wealth with a 15 yr mortgage. 

Bottom line: More often than not I see and hear people who show why a 30yr mortgage is better, which makes others believe that's the ultimate way not thinking about the simple case of Jerry which may even represent them. I know this post will result in angry replies but all my intention was to bring a different point of view that would support Scott T's saying that the choice between the two depends.

* That may seems like a fast pace to save that much, but in reality it's possible to save a lot more especially when the spouse works as well

** The rates were taken from bankrate.com and are relevant to 8/5/2016

[Steve Vaughan]

I completely agree with your assessment, Assaf. For the lousy $179/mo (that most people blow on fancy coffee and/or car payments anyway) we will be done with the stupid mortgages, while the 30s still have a 75% balance. We also shed years off of paying PMI at $75 per $100k borrowed every month.

Mike, the rate on your 30 is much higher, so the math won't work just applying the larger payment. Look past Friday. If less than $200 derails all of our plans...

Theorists and theories are just that. A bunch of guessers with a calculator. My mortgages are dropping like flies and I can tell you I don't sweat an extra few hundred a month in available cash flow. I do not look back and wish I had managed my payment risk by stretching my pmts into the next century or feel I have squandered the $178 a month on a low ROI investment. Cheers!

[Mike Hanneman]

How does the math work if you would take the $538 and apply it to the 30 year payments. This way if you get in to a hardship for a month or two you can pay any the minimum and have a little extra.

I don't think there is a right or wrong way to do this. It just depends on the person's preference and what are their goals.

For me I prefer the 30 year and I pay extra every month, but can see where a 15 year can be a benefit.

$20K a year in savings!!??? That's huge, most of America can not and won't be able to do this even working two jobs each!

[Thomas S.]

The problem with your theory is that you have totally ignored the value of equity- cash lying dead in a property.

If you apply a return to the 1M of 5% that by itself is worth $4166/month reducing his $5380 additional income from the properties to a measly $1213/month. Not really worth the effort in the end.

Paying down a property does not in reality increase cash flow at all it simply transfers the income stream from the property to the equity. Additionally the 5% I have used as a example is extremely low compared to the return he could get if he used the 1M to purchase additional properties at minimum down. He could double or triple his monthly income if he concentrated on cash flow as opposed to accumulating equity.

Equity does not buy groceries. You have to cash out to benefit and then what do you do with it ????

[Steve Vaughan]

I completely agree with your assessment, Assaf. For the lousy $179/mo (that most people blow on fancy coffee and/or car payments anyway) we will be done with the stupid mortgages, while the 30s still have a 75% balance. We also shed years off of paying PMI at $75 per $100k borrowed every month.

Mike, the rate on your 30 is much higher, so the math won't work just applying the larger payment. Look past Friday. If less than $200 derails all of our plans...

Theorists and theories are just that. A bunch of guessers with a calculator. My mortgages are dropping like flies and I can tell you I don't sweat an extra few hundred a month in available cash flow. I do not look back and wish I had managed my payment risk by stretching my pmts into the next century or feel I have squandered the $178 a month on a low ROI investment. Cheers!

[Joe Villeneuve]

I completely agree with your post @Thomas S. The statement agree with that you made is that many squander that extra CF on something.  What if it was designated to pay the gas bill, or the cable bill, or some other bill?...and then that equity that is now working for you invested in another CF property that had a 30 year mortgage with higher CF (than a 15) and that extra CF paid the electric bill, or the car payment, and so on and so on. 

[Jerry Limber]

Can I just say Assaf Furman that this post freaked me out when I first started reading it. My name is Jerry (same as your example) and I am 32, have a good W-2 job and strongly prefer 15 year mortgages on my investment properties.

My plan is very similar to what you describe in your post, keep buying a new property every year so that in my 50's I can choose to retire if I want.

I completely understand the flip side of this argument on why 30 year mortgages are better. However for me, since I don't need the short term cash flow and am able to stash away enough cash to keep buying properties every year based on my salary, it works better for me.

The reality is, I don't have time (or least choose not to spend my time) buying properties at a faster rate than I currently am. I'm not a full time real estate professional. This is my long term retirement plan and the peace of mind provided by the faster equity pay down is preferable to leveraging myself into oblivion for the next 30 years.

-Jerry

[Brendon Woirhaye]

Different terms fit different scenarios.  Perhaps if your name is Jerry, the 15 is always ideal* (theory not substantiated with evidence).

Also consider the tax implications.  As you pay less interest in the later years, you lose that expense and more profit falls through to the bottom line.  If you are still W2 employed, you may push your income into a higher bracket.  Not a terrible problem to have, but a consideration.  

Personally I use 30 year loans when I can, because the rates are low and I want to maximize my leverage, even though I know I will pay more in interest on them long term.

[Assaf Furman]

@Mike Hanneman @Thomas S.

[Thomas S.]

The reality is that over a 15 year period well leveraged investments will pay dividends far beyond what can be realised by squirrelling cash away in a mattress, I mean a property.

With interest rates as low as they are paying off a mortgage is returning almost nothing as a investment vehicle. Rather than earning the equilivant of the mortgage interest rate as a return on my cash I think I will stick with my 20% return on leveraged investments.

[Ben Leybovich]

What you are missing is that as the property, any property, gets older, it requires more CapEx. Additionally, the Cost Segregated depreciation schedule breaks even after about 6-7 years.

For the above reasons, most investors do not hold property for longer than 7 years. There are exceptions, of course, whereby intrinsic desirability is so strong that it makes sense to hold forever. But, by and large, because of the above realities, 30 years makes most sense.

The only time and place where 20-year notes are better is poor non-appreciating markets :)

[Assaf Furman]

@Ben Leybovich You brought up property expenses, depreciation and the recommended holding time as a result. There are other factors as to why you'd might want to hold a property for a shorter time - all that is beside the point that I was trying to make.

Would you care to explain why it's only good for non-appreciating markets?