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Are Shorter Mortgages a Smart Move?

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With the financial markets as volatile as they've been lately, everyone's looking for a sure thing. Increasingly, savvy homeowners think they've found it, and the latest trend has them putting more of their spare cash toward what once would have been an unheard-of "investment": getting their mortgages paid off faster.

A world turned upside down
It says a lot about the investing environment we're in that even with mortgage rates at record lows, people are seriously considering ways to pay down their mortgage debt faster. In the past, when interest rates fell, most homeowners rushed to refinance in ways that pulled out additional equity and made the most of interest savings over the long haul.

Instead, as an article in The Wall Street Journal over the weekend observed, homeowners are interested in getting their mortgage debt paid off faster. Nearly one in three borrowers who refinanced their mortgages during the first quarter replaced a 30-year fixed mortgage with a shorter-term loan. In addition, 15-year mortgages have gained in popularity even outside of the context of refinancing.

Part of the appeal comes from a particularly wide spread between rates on 30-year mortgages versus 15-year loans. At 2.83% for 15-years versus 3.53% for 30-years, the spread is the widest it's been in the 20 years or so that government mortgage-tracker Freddie Mac has kept records.

Faster payments
But those lower rates come with a catch. In order to pay your loan off in 15 years versus 30, your monthly payments must be significantly larger. For a $200,000 loan at the rates mentioned above, payments on a 30-year would be just over $900, while a 15-year would require payments of almost $1,365 per month.

The key, though, is that all of the extra $465 is going toward repaying principal. So it's not as though you're actually losing that cash; it's going toward building up equity. In addition, you'll pay almost $1,500 less in interest during the first year of your mortgage, with that extra $1,500 also going toward paying down principal.

A smart investment?
Getting out of debt definitely has appeal for many people right now. But with mortgage rates as low as they are, should you be in any rush to get your mortgage paid down any faster than you have to?

The answer depends on what you would do with the money. For those who have money stuck in savings accounts or money market mutual funds earning almost no interest, the chance to earn essentially 3% in interest by paying down a mortgage early makes some sense.

But if you're willing to take the risk of putting that money into the stock market rather than using it to pay down mortgage debt, it's a much closer call. By keeping your mortgage higher, you'll pay that roughly 3% in interest, but for many people, the interest is tax deductible. As a result, you'd only need to find investments that return 3% or more in order to end up ahead.

Dividend investors will point out that it's relatively easy to get yields of more than 3% from a wide variety of dividend-paying stocks. Although the irony of taking money you'd use to pay down your mortgage and investing it in mortgage REITs Annaly Capital (NYSE: NLY  ) or American Capital Agency (Nasdaq: AGNC  ) may seem attractive, you don't need to stretch for double-digit rates to meet a 3% bogey. You can even choose from a number of blue chip Dow component stocks, with pharma giant Merck (NYSE: MRK  ) and telecom rivals AT&T (NYSE: T  ) and Verizon (NYSE: VZ  ) among the least volatile from a shareholder perspective.

Just remember that using money to invest in dividend stocks rather than paying down a mortgage isn't a sure thing. While the dividend cash flow may help you make your monthly payments, you still have the risk that the stock price will go down, leaving you behind on the deal.

Taking responsibility
Leaving aside the pure numerical arguments, though, it's refreshing to see people taking responsibility for their finances more prudently. As useful as leverage can be, using it unnecessarily adds risk to your financial situation. If that trend continues, then the average household should find itself much more financially stable in the years to come.

All that said, you still need to invest some of your money toward your other financial goals. Find out some great stock names to consider for your portfolio by accepting this free invitation to read the Fool's special report on long-term investing. Inside, you'll learn about three stocks to help you retire rich. Get your free copy today while it lasts!

Fool contributor Dan Caplinger hasn't hesitated to make extra mortgage payments when the will arises. He doesn't own shares of the companies mentioned in this article. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of Annaly Capital. Motley Fool newsletter services have recommended buying shares of Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy won't leave you without a roof over your head.


Read/Post Comments (15) | Recommend This Article (13)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 26, 2012, at 11:20 AM, damilkman66 wrote:

    I can only speak about myself. I went from a 30 to a 20 not for investment reasons but because I was ten years into my 30. I want it payed off at the same time. If I were to refinance again in about 5 years, I would go into a 15.

  • Report this Comment On July 26, 2012, at 1:41 PM, ejazz2095 wrote:

    I've heard this argument many times. The only thing I can say is that the people I know that are the most well off financially - don't have a mortgage.

  • Report this Comment On July 26, 2012, at 3:08 PM, PigsFly27 wrote:

    "By keeping your mortgage higher, you'll pay that roughly 3% in interest, but for many people, the interest is tax deductible. As a result, you'd only need to find investments that return 3% or more in order to end up ahead." Isn't this false? Since you are not only giving up the 3% interest savings on paying off debt but also the (from your example) $1500 in interest now going to principle. So your extra cash flow of $5,580 would need to earn more $1,667 (1,500 and 3% of 5,580 - or more than 29%). I am sure these quick numbers are not 100% accurate, but they seem to point to choosing a 15 year mortgage instead of 30 year if you are refinaning and have the cash flow for the 15. Am I looking at this wrong?

  • Report this Comment On July 26, 2012, at 3:10 PM, fool3090 wrote:

    We went from a 30-year 4 5/8 percent to a 15-year 3 percent. The monthly payment was 10 bucks LOWER... and we pay the thing off in half the time. We had mad accelerated payments on the original loan, so that put us in a great position to refi. Will save many tens of thousands of dollars in interest by doing this.

    High FICO scores, tons of equity, stellar payment history, and a great community bank. That's what the secret is. Unfortunately, the folks that need better loan terms are underwater, or have credit blotches or bank at a too-big-to-fail institution. Oh the irony... people who need money the most are the ones not likely to qualify for money.

  • Report this Comment On July 26, 2012, at 3:20 PM, acb29 wrote:

    15-year Mortgages are ideal, just run the numbers and look how much you save in interest. Interest tax deduct-ability offers some relief but its no silver bullet, see the post above why this is so. At the end of the day its better to pay off your mortgage early and invest the money saved into something that give you real returns, not just some marginal tax credit. golden rule: You can't make money , by saving on spending money..

  • Report this Comment On July 26, 2012, at 5:20 PM, robyrob wrote:

    We've gone from 30 to 25 to 20 - all with approx the same payment - in the 4 years we've been in our home. I like the idea of being without a house payment in 20 yrs or less, but it's also important to recognize that can't be your only strategy. Maybe try and max your IRA contrib first.

  • Report this Comment On July 26, 2012, at 5:28 PM, GrumpyOldGuy wrote:

    If you think interest rates are going up, up, up on you, then go for the long term, fixed rate loan. Nothing like paying the bank 4% on your home and the bank paying you 8% on your CDs. Of course it stinks to pay 4% on your home and have the bank pay you 0.5% on your CDs.

  • Report this Comment On July 27, 2012, at 9:28 AM, WestBend1 wrote:

    A rule I once heard: If it takes longer than 30 seconds to explain how you will make money (or be better off), then you are most likely better off not doing it.

    In my experience as a banker, for the average person less debt is better. It is not hard to explain that a person pays less interest on less debt. Try to explain to the average person to be patient when the market is stealing their savings. I think a lot of the people I work with think a mutual fund is like a bank account that either has money taken out each day or added each day. They don't understand it is a "value if sold." So agree and encourage my customers to pay down their mortgages faster.

  • Report this Comment On July 27, 2012, at 9:30 AM, WestBend1 wrote:

    Correction:

    "So I agree and encourage my customers to pay down their mortgages faster."

  • Report this Comment On July 27, 2012, at 1:33 PM, StopPrintinMoney wrote:

    Good all Wall Street hymn about annual 8% market return and 5% dividend yield. They keep talking about it, but can't deliver it when asked.

    I personally have a paid-off house and live the life I want rather than having both mortgage and an account that may lose 50% in a matter of several months.

  • Report this Comment On July 28, 2012, at 12:11 AM, lowmaple wrote:

    stopPrintin: It is great to have no mortgage however that 50% is only if you have to sell. And if you buy strong dividend companies that dividend will easily rise over 5% in time. I have some now paying 10% plus, but only after 15-20 yrs for the safe dividends

  • Report this Comment On August 03, 2012, at 1:05 PM, eyarden wrote:

    If one is living on income from SS and pensions as well as paying a mortgage in which housing prices move only up, refinancing at less than 4% while increasing the amount of a 30 yr fixed rate 5.8% mortgage and converting to 20yr mortgage is a good way of spending surplus income. Property usually provides the best inflation hedge.

  • Report this Comment On August 03, 2012, at 4:43 PM, Jdecota wrote:

    It depends. If your a small business owner, that floats inventory, a bank might not like what happens to your ratios because of the increased " committed payment" of a 15 year note.

    There's no rule that says you can't pay off a 30 year note in 15 years. The question is do you have the discipline to make the extra payment, or will you blow it on a BMW lease payment.

    I'm a fan of liquidity, I saw a number of people lose their job, and then lose the ability to get the extra payments they made on their mortgage back from the bank because the bank said they don't qualify.

    Why can't u operate under the pretense of paying off your house in 15 years, but accumulate the extra payments in an account that you have access to. That way the funds are liquid should you have a major financial event. This money is in addition to a 3-12 month cash surplus.

    In summary, it depends, on who you are and how well you know yourself.

    JD

  • Report this Comment On August 04, 2012, at 3:48 AM, bobble293 wrote:

    In the UK, we no longer have mortgage interest tax relief, so no benefit there in having a mortgage.

    We had interest rates as high as 15.5% in the 80's, (for a relatively short time) when I was obliged to raise my mortgage payments. When the interest rates dropped, I continued to make the higher payments. The result was a mortgage cleared in 11 years, and much less interest paid.

    I recommend paying as much as you can to get the banking parasites off your back as soon as you can, but I accept that not everyone will find that possible. (Some may not wish to forego their expensive 'phones, clothes, social lives etc. to achieve it)

  • Report this Comment On August 04, 2012, at 4:21 AM, TerpFan90 wrote:

    All very good preceding comments, a common theme seems to be that it depends on your situation. I subscribe to the rule that I invest wherever I can get the best return. If I can get a better return than the tax adjusted rate on my mortgage with a minimal amount of risk, then that is where I will invest. With that said, there is a great deal of security and satisfaction owning your house free and clear. My Mom who is in her 70s recently paid off her mortgage with accelerated payments even though she had the retirement income to support her low interest and she couldn't be happier with her decision.

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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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