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December 20, 1999
"Your recent column
suggested that a larger down payment can be viewed as an investment
yielding a return. This made me wonder whether you can view a shorter term
mortgage in the same way?"
Indeed you
can, and this is a very insightful way to look at it. A shorter-term
mortgage is an investment, although it is a little different than most
other investments.
Typically, an investment consists
of a lump sum paid out at the beginning, and the return is a series of
payments received over time. This is the way it is, for example, with
investment in a deposit or bond.
By contrast, when you invest in a
shorter-term mortgage, your investment is a series of payments equal to
the difference between the monthly payment at the shorter term and the
payment at a longer term. And the return is a lump sum, equal to the the
larger proceeds you receive at time of sale because of the smaller loan
balance that must be repaid at the end of the period.
Let's say you are borrowing
$100,000 and choosing between a 30-year fixed-rate mortgage (FRM) at 7.5%
and a 15-year FRM at 7.125%. The .375% difference is typical. Monthly
payments of principal and interest are $699.22 for the 30-year loan and
$905.84 for the 15-year. The difference is $206.62 each month. That's your
investment.
You expect to stay in your home
seven years. At that point, the balance of the 30-year loan will be
$91,833 and the balance of the 15-year loan will be $66,137, for a
difference of $25,696. That's your return. On an annual basis, it amounts
to 10.72%. If the difference in interest rate had been greater than .375%,
the return on investment would be higher, and vice versa.
The calculation above assumes the
interest rate is the only difference between the two loans. But if the
down payment you expect to make is less than 20%, you will have to pay for
mortgage insurance, and the premiums are higher on the 30-year loan. This
increases the return on the 15-year loan considerably. If you anticipate
paying 5% down, for example, the higher premium on the 30-year FRM will
raise the 7-year return on the 15 from 10.72% to 15.74%.
An important feature of this type
of investment is that the return is inversely related to how long you
expect to stay in your house. If you remain 3 years instead of 7, for
example, the return on your investment in the case without mortgage
insurance rises from 10.72% to 16.21%. If you remain for 15 years, the
return falls to 8.60%. That's because you must wait 15 years to realize
the return.
Rate
of Return From Investing in a Shorter Term , a calculator available on
my Web site, lets you calculate the return on your own deal. You enter two
terms, their interest rates, your anticipated down payment and your
expected period in the house. The calculator determines your rate of
return.
This way of looking at a shorter
term reveals how much more effective it is as a way of building equity than the common practice of systematically making additional monthly
payments on a 30-year loan. Assuming you aren't paying PMI premiums,
the rate of return on the additional payments made on a 30-year
loan is just the interest rate on the loan. If a 15-year loan is elected
at the outset, the return is substantially higher, especially if you don't
expect to be in the house very long.
Most borrowers electing a 30-year term do
it because they can't afford the monthly payment on a shorter term. Some
elect the 30-year term, however, because they plan to invest the
difference in payment. To make this a sensible investment strategy,
however, the return must be higher than the return on a 15-year mortgage.
Not many borrowers have access to such investments.
Copyright Jack Guttentag
2002
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