MAKE A 15 YEAR PLAN ON A 30 YEAR TERM

Stuff happens. Life happens. Things go this way or that way, and rarely the way we envision. Fifteen year plans are good plans, but plans are only as good as they are relevant to be exercised. Change circumstances, and it doesn't matter how good a plan is if it is no longer relevant.

Thinking in 15 year "chunks" instead of fixed mortgage terms helps protect you from some of these changes. For example, the chance of moving and selling because of a job or family change may be high, but that does not have to reset your payment schedule even if it does reset the mortgage. So Tip Number Two is designed to get you tangible ownership in 15 years if things go to plan.

But perhaps they won't. They may get better, in which case there is an embarrassment of riches in choosing how to exercise one's next step. Or they may get worse. Actually, the way life is, better and worse are somewhat loaded terms—though no doubt not entirely vacuous, as indeed "worse" really can be "worse." So as important as it is to plan for success, we need to plan the downside.

We are going to position for the upside by budgeting for a 15 year mortgage (Tip Number Two), but we are going to prepare for the downside by taking a 30 year loan. So for a $200,000 loan at 6%, we are going to budget a monthly payment of $1,687.71 (the 15 year payment), but we will have a minimum payment due of $1199.10 (the 30 year payment).

The days of prepayment penalties for conventional, U.S., fixed-interest mortgages are for the most part long gone: there is no prepayment penalty and you may pay as much (but not as little) as you like. So a 30 year mortgage absolutely does not mean you must pay at only the 30 year monthly rate; you can still pay at the 15 year rate or any amount you choose so long as it is above the minimum. (Prepayment penalties do exist on some loan products, and even for popular mortgages in some countries, so do not assume they do not exist for you: check and verify).

A 30 year mortgage requires "only" $1,199 as a minimum monthly payment—about a $500 difference from the 15 year $1688. So if times get tight, if we get laid off, or want time away from the regular job to start a new business, or meet unexpected medical bills, we will have a cushion of almost 30% ($1,199 / $1688) to reduce our monthly payments over an open-ended period of time. Once we are back on our feet, we can catch up and over-pay to our heart's desire.

This "insurance" has a cost: the interest rate on a 30 year loan is higher than on a 15 year loan. The spread between the interest rates varies with the market, so it is worth running both numbers. But somewhere we need to build in protection. We want protection that protects: that means it is reliable, and is there when our back is to the wall and we really need it. So we want as few "schemes" as possible, and a guaranteed lower monthly payment whenever we want it (the 30 year minimum vs. the 15 year minimum), without asking anyone for anything, completely at our discretion.

One may ask: "If you want insurance, why not buy insurance*? There are plenty of mortgage and even living-expense insurance products out there." Indeed there are. They may be good for you; they may even be cost-effective. But invariably, they are a product; that means there are conditions, and circumstances, and fine-print, and everything else that comes with an insurance product. The more that an insurance product covers a likely outcome, the more expensive it will be relative to the protection it provides. The more it protects just a catastrophic outcome, the rarer it will be to exercise. A 30 year note is not catastrophic insurance—there is still a monthly payment; a 30 year note is simply a cushion for unforeseen times that may pressure your 15 year budget.

If we cannot afford the 15 year budget on a regular monthly payment basis, then that is a sign to us that we should not be in the $200,000 loan range. We should be shopping for a house that we can buy with $142,098—since that would give us the 30 year monthly payment that we can afford ($1,199) but over 15 years. The minimum 30 year payment on $142,098 is $852, so the $347 difference ($1,199-$852) is our 30% cushion. Remember Miles and Holiday? Borrowing less now and paying it off quicker enables them to more than compensate later.

And compensation later works at any level. If a 15 year is solidly comfortable, then consider taking a fixed 15 year loan and using it to get your house paid in even less time. Ten year horizons are really nice for those lucky enough to be able to exercise them. Three '10 year plans on 15 year terms' to arrive at the same 30 years of payments offers aggressive savings: you will save half a million dollars by growing into a $600,000 home in three, 10 year, $200,000 steps than by financing $600,000 all at once over 30 years (those payments will exceed $1.2 million). Plus in the smaller homes in the earlier years ($200K years 1 - 10; approx. $400K years 11 - 20) you will acquire equity faster, so you will get more of your cash back if or when you move, and be better prepared for life's various surprises. Do you live in an area where $200K barely buys a closet, and $600K is the bare minimum? Then all-the-more, short terms amplify your savings and offer an aggressive counter-plan to traditional 30 year, minimum payment plans.

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^*The insurance discussed here is not the same as PMI—Private Mortgage Insurance. PMI is insurance for the lien-holder (i.e., the lender), not you, in case you default. The lender will make you buy it and make you pay for it if your loan is for more than 80% of the assessed value of the house. PMI benefits the lien-holder (its insurance for them, paid by you), and possibly you (allows the market to offer slightly lower interest rates and accept lower down payments for a given level of risk).

Presumably this payment plan has been around since people first started figuring out ways to avoid financial indentured servitude. It is certainly not unique to this site, but is known as one of many possible payment plans. It has some very nice properties for you, and a few of which to be aware.

At the beginning of the loan we owe the most, thus the interest payment we owe is the highest, so the amount of the monthly payment that goes to principal is the lowest. Indeed, in Month 1, next month's principal payment (Month 2) on a 30 year at 6% on $200,000 is just $200.10.

So we are budgeted for $1,688 (the 15 year amount), but let's consider that we pay only the minimum due plus next month's principal: $1,199 + $200 = $1,399. We're under budget!

Now Month 2 arrives. But we've already paid that month's principal. You can just cross a line through that month—interest and all. We would have owed $999 in interest for that month, but because we paid that month's principal just one month early, that $999 in interest is completely wiped out. Zero. We spent $200 one month early and saved $999. That's a good deal.

It is important to note that the $999 savings is only realized, non-inflation adjusted, over the full scheduled term of the loan (30 years). If we pay off the loan early and exit the game we won't see the entire savings. We may think that if we pay $200 thirty days early, then we save only 1/2% of $200 or $1. That is the case if we repay the entire loan at the end of that month and then call the whole thing "quits." But for each month we do not pay back the entire loan, the savings accrue. By paying the $200 thirty days early, the entire loan payment schedule shifts forward one month—so now we will be paid off in 359 months instead of 360 months, etc., etc. That is why in Tip Number Two we think in terms of our total savings, over an entire life's payment span of 15 to 30 years, regardless of the number of mortgages.

So what do we pay in Month 2? It's easy. We'll pay our regular payment plus the next month's scheduled principal (Period 4). The table is below:

Again, we are going to get another month "interest free" simply by paying just the principal just one month early. In Month 2 we pay $1,199.10 + $202.10 and "save" $997. So in two months we paid an extra $200 + 202 = $402 of money we owe anyway, and saved $1,996. That's a great deal.

The benefit of this is greatest at the beginning of the loan, since that is when the differential between the interest portion of the payment and the principal is the greatest—i.e., we get the greatest interest savings for the lowest extra payment. We can stop or restart any time.

If every month we pay two months' principal instead of the usual one month, then the loan will be paid in half the time. This must be so, since we are paying two-for-one. So we will pay off this house in 15 years. This is important for us, because we are committed to a 15 year period, and we see we are paying the loan over 15 years. We took the 30 year loan to set up a buffer for us (a lower minimum monthly payment) in case of bad times.

The flip-side of this plan being so attractive by using low extra payments at the beginning of the loan, is that the payments get larger and larger as the loan progresses. That's because "next month's" principal component gets larger. That means that our monthly mortgage payment increases each month—something that can be hard to budget. For example, on month 90 we hit our 15-year monthly budget of $1688:

And indeed, by end of the loan, two months' principal is essentially twice the minimum payment. By month 180 the loan is paid off, but the monthly payment has essentially doubled:

So what happened to our monthly budget and wiggle room?

The wiggle room is still there because the loan with the bank was at a fixed rate for 30 years, so the minimum payment in an emergency is still $1,199; well below our budget. This is important for Tip Number One.

But what out our budget of $1,688? We are high by $704, 15 years down the road.

The fix is quite simple.

An obvious correction is to simply cap our monthly payment at our budget. After all, that is our budget. Yet actually, we may be able to have our cake and eat it too.

If inflation is as low as 3% (the approximate historical average), then after 15 years our $1,688 budget is equivalent to $2,630—greater than our maximum payment of $2392. In other words, inflation-adjusted, we remain within budget. Thus the adage: Inflation helps borrowers. So with this plan of 'paying next month's principal this month' our monthly payment is not only manageable in the beginning, but stays within our inflation-adjusted budget for the life of the loan.

Still, we want to exercise some care. Payments only get "easier" with inflation if our take-home pay goes up with inflation. And that's something that has not been happening this last decade:

Customize | FRED - Economic Data from the St. Louis Fed

Inflation without a concomitant rise in wages definitely does not help borrowers. Recently, inflation has not been as high as 3%. Stagnate wages and falling labor share are disinflationary—there can be no consumer-driven price inflation if people do not create pressure on rising prices via increased demand, because they simply do not have the money to spend.

Thus the double-edged sword: inflation with wage increases helps offset the rising monthly payments; while little inflation, or worse yet, stagflation (rising inflation with rising unemployment and/or stagnant wages, for example as driven by supply-side shocks on commodities) make a disciplined plan even harder.

So let's look at this rising monthly payment from another angle, because we really want to know if it is a good or bad idea. Is this not like the rising monthly payments that so hurt people in the sub-prime crisis? It is not and here's why:

In the sub-prime crisis people were buying homes with little money down, with so-called "teaser" variable low rates, and sometimes qualifying for loans that stretched their ability to pay given the known, long-term expected rise in rates. They expected that eventually the rates would rise and so would their monthly payment. So the plan was to let the market-rise in asset values create equity (the difference between the loan and what the house is worth), and to then refinance at better terms in the future as increased market-driven equity created a stronger qualifying set of credentials.

But as the bubble grew, ultimately home values did not increase; indeed, they finally dropped—precipitously in many cases. Because the house was bought with so little money down, there was little equity, and the owners soon became upside down in their loans—owing more on the loan than the house was worth. This killed any refinancing, so they where stuck when their rates increased. Critically, when rates did increase, it increased their minimum monthly payment, and blew their budget. Even worse, when national rates later went down in response to the crash, down to some of the lowest levels in history, they could not take advantage of them because they were still upside down and thus could not refinance.

Our plan is much different. For starters, our minimum monthly payment (the 30 year term amount) is permanently fixed below our budget (the 15 year term amount) for the life of the loan. Remember: if you can't afford the house on the 15-year plan, you don't buy it, even if you are taking a 30 year mortgage. So we have built-in guaranteed wiggle room—the exact opposite of what happened with the variable rate loans. Secondly, our payment plan remains absolutely under the non-inflation adjusted budget for not just a few years, but for half the accelerated payoff time (7 1/2 years). Thirdly, in the later years when we are planning on paying more than our initial budget, it is never more than an inflation-adjusted budget, and we always have the option of paying under budget.

Still, no one can predict inflation. So let’s be very conservative: assume we start on plan and pay no more than the 15 year budget, and once we hit that level stay on it as the original, non-inflation adjusted budget. Result? It adds about three years to our plan—in other words, we will be paid off in 18 instead of 15 years. Not our best-world target time, but safe, within budget even if ignoring inflation, and much better than a 30 year alternative.

When all is said and done, the lower earlier payments are not completely offset by the later higher payments. Under this plan you pay slightly more than a straight conventional 15 year mortgage, yet much less than under a 30 year plan.

Investing the difference: 15 versus 30 year mortgages

Some say that you should get a 30 year mortgage and invest the difference between the 30 year and 15 year monthly payment in something other than your house—such as in stocks. In our example of a $200,000 loan at 6%, the difference between the 30 year and 15 year monthly payment is about $500. For many people investing this difference is not a good idea.

Below is graph of the performance of the stock market, log-scale, inflation adjusted, dividends reinvested, since 1871:

Data from R. Shiller, Yale Univ.: www.econ.yale.edu/~shiller/data.htm)

Average compound annual growth rate (CAGR) is 3.6% (and less, 2.2% without reinvesting dividends). There were long, secular spans where the market was brutal: for example, in the 15 year bear market from 1968 to 1982 inclusive, one would have lost 43% inflation adjusted. That's a real loss. And presumably, not only did one lose in the market, but missed the mortgage savings, as the money was invested rather than being used to pay down the note. Shift a market cycle to 1983 to 2000 and one would have more than compensated with a whopping 473% gain. (Other analyses arrive at other figures, notably on their treatment of dividends; see for example Doug Short's Secular Bull and Bear Markets). These secular cycles are so long (average, 17 years), that one cannot plan one's life around market cycles.

With a loan at 6%, you know you must beat a 6% return in the market just to break even without any "friction" and must do that for a long period of time. In practice, after one factors in fees, transaction costs, capital gains taxes, indirect costs of unrealized house equity, market timing, and other factors, it is often difficult to do better in the market than just using your money to pay off the loan. There is a well known theorem in mathematical gambling that there exists no betting scheme that can out-perform the mathematical odds of the game: in other words, no matter how you play, the longer you play, the more you will approach the mathematical expectation of the process. From the figure above, that means beating 3.6% + expenses over the long run.

Trying to beat 3% or 6% or 9% is not by any means impossible given some cherry-picked time-frame, particularly if you have a low interest loan on the "cost" side and an aggressive post-2009 bull market on the "earnings" side. Indeed, this is essence of how market pressure continually shifts capital flows to areas of higher yield. And since the equities market incurs more risk than mortgage backed securities, market participants should be realizing gains that exceed what mortgage payers can save. But this argument gives us little actionable intelligence on when and how to invest, and consequently we must be cognizant of the very real chance of substantial losses within any given period of performance. So why work so hard to do something so difficult—something that fundamentally confounds securities investment with personal home ownership—when just paying off your loan gives you a guaranteed and predictable return on your money? Paying an extra $200 a month on a 6%, $200,000, 30 year loan saves $79,801 guaranteed, non-inflation adjusted. Fifty thousand dollars of that is realized as the loan is paid off in 21 years, with the remainder in the nine interest-free years from years 22 - 30. Pay the loan in 15 years and you'll save $127,889 no matter what the market does. If you want inflation adjustment, simply discount at 1%, 2%, 3%, ... per year or whatever your Oracle of Delphi tells you.

Make it easy on yourself. Your monthly mortgage statement should tell you at least what your current principal payment is for "this" month, as well as the total payment. "Next month's principal payment" is very close to this month's, so just double the number and round up a little. It will be quite close.

What about getting a 30 year mortgage, but just paying extra without a double-principal plan? This begs the question of "How much extra?" Certainly you can pick a figure: $100, $200, $300; nothing wrong with that. Another plan is to make semi-monthly payments every two weeks, instead of once a month. Because people often get paid every two weeks, this is a convenient way to pay a little extra on the mortgage. It has the added benefit that there are 26 biweekly periods in a year, so you end up making the equivalent of 13 monthly payments a year instead of the usual 12. This will take approximately 8 years off the life of a 30 year mortgage. That's good, but 22 years is still a long time to pay on a single note—about 50% more than the 15 year plan.

Exactly how you get to a 15 year plan is less important than actually doing it. So if the double-principal plan works; use it. If you like the stability of regular, non-changing monthly payments, then do that.

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