You’ve seen them everywhere. The ads comparing a 30-year mortgage to a 15-year. By now, most of us have a handle on the simple math. The typical 15-year mortgage comes with a lower interest rate than 30-year. Interest is front-loaded on the amortization schedule (in simple terms, when you look at your monthly payment, most of your payment is applied to interest rather than paying down the principal). Over time, more and more of your payment is going to principal. So why compare these options?
Let’s start with the overall interest paid over the life of a loan. Simple math (there are online calculators to do this is well) shows that a 15-year note can save you tens, if not hundreds of thousands of dollars depending on the loan amount. The caveat: your monthly payment will be substantially higher in most cases. Even when the financial picture looks good, that could be a difficult commitment. After all, you are locked into that payment without many options if you lose your job or things get tough. Also, lending guidelines and restrictions may make it more difficult to get approved for the payment in the first place.
With all of that being said, it can certainly make a lot of sense to go for the shorter repayment term. Don’t forget about the option of just making additional principal payments on a 30-year loan (requires discipline, but it would almost result in the same outcome as the shorter note). So, what does this all have to do with the concept of “good debt” and is there such a thing?
In another post, we will get deeper into the concept of leverage. This is simply a method of acquiring property via a loan compared to using your current capital. Real estate investors look at this ratio often as a means of weighing investment risk (and they should). But for the average homeowner evaluating their primary residence, how should you feel about debt? Many advisors will tell you having a mortgage is OK, and for most of us it’s not really a choice if you want to own a home. Who has hundreds of thousands of dollars laying around? But if you listen to some of the heavy influencers out there in the financial space, there is an emphasis on becoming debt free. Debt comes with an ugly connotation, because it is usually expensive and hinders your long-term financial independence goals. Not only are your funds going to interest payments, but you are losing out on the opportunity cost of what you could do with those funds if you weren’t servicing debt. In short: attack expensive debt quickly i.e. credit cards and lines of credit that carry a high interest rate.
So, is a mortgage “good debt”? Let’s go as far as to say that it’s usually necessary, and always a good idea to do the math. Understanding your options, weighing them against each other, and figuring out the best path for your financial picture is the name of the game. This can usually be done in a written financial plan which simulates the different outcomes over the long-term. In most cases, it works out better to approach debt quickly. If you can’t do that, then seeking the least expensive debt is the next best thing. We are experiencing some very interesting times right now, and interest rates are still very low. If you have not looked at your current rate for a potential refinance, it may be a good idea to do so. Just be sure to do the math!