Introduction

When I was first considering purchasing a home, I was really hung up on being in debt for 30 years. It took several people explaining it to me before I really understood why I should do a 30 year home loan instead of a 15 year home loan. First off, here is the simplified way that they explained it to me (if it confuses you, don’t worry…it confused me too. I’ll explain it).

The Short Answer

The difference between a 15 year loan and a 30 year loan is basically two things. With a 30 year loan, you will be paying more interest on the house, which is tax deductible. Because of this, you can really think of it as lowering your interest rate to borrow the money for your home. If your interest rate is 6.5%, you can really consider that around 5.5% after you account for taxes. The other factor you have to consider is the difference in the amount of money you will be spending per month. If your payment would be $1,500 per month with a 15 year loan, and $1,000 with a 30 year loan, you have $500 extra that you can invest every month.

Now when you put these two factors together, you have to think of what rate of return you could get on that difference in money if you were to invest it. You could pretty reasonably get 10%-12% interest on any money you invest. That means you could be making 4.5%-6.5% on $500 each month. That 4.5%-6.5% is obtained from the 10%-12% you could make on the market, minus the cost of borrowing money for your home, which in our example case is 6.5%, and then subtracting the tax break of 1%.

The Long Answer

Well, that’s all good and well to say that, but quite frankly I had a really hard time wrapping my mind around it. So here are some more details that may make it easier to understand. I will be using the actual numbers that I am dealing with, but regardless of the exact numbers, this almost always works out to benefit taking a 30 year loan as opposed to a 15 year loan.

Interest Rate on Borrowed Money: 6.625%
Interest Rate on Investing Money: 10%
Amount of Borrowed Money: $166,000
Tax Bracket: 28%

In this example, I will assume that any tax break we receive because of written off interest will be invested. I will also assume that we can afford to take out a loan for 15 years, but if we take out the loan for 30 years, the difference in monthly payments will be invested (since this is what the entire argument for 30yrs vs. 15yrs revolves around).

In the following table, the 15 year data is on the left hand side of the table, and the 30 year data is on the right. Each row represents the values at the end of each year. The “Total Investment Value” column also adds the interest you would have made if you earned interest for the entire year on the amount invested that year. After 15 years, we will assume that all the money that used to go towards house payments will be invested.

As you can see, even if we want to take a snapshot of our financial situation at the 15 year point, on one hand we would have around $75k worth of investments with $0 owed on our home, and on the other hand we would have around $265k in investments, and owe $121k on our home (net worth of roughly $144k). So at this point, the 30 year loan would make us about $69k wealthier, with the only requirement being that we spend the same amount of money each month in both cases.

If we continue for the last 15 years of the 30 year loan, and assume that we are investing everything that we no longer have to pay in house payments, then the difference in wealth becomes even more apparent. At the end of our 30 year term, we now have $925k vs $1.3 million. Therefore, the 30 year loan allowed us to amass $400k more than the 15 year loan would have.

Now, just for fun, here is a table that shows how much these investments would earn if you never put another penny into them, but let them continue drawing the same rate of interest.

Now, just a quick disclaimer, in your older age, you most likely would invest in things that are a lot safer and would not return you such a high interest rate. But it is neat to see how when you are dealing with this amount of money, you are earning $150,000 each year just off of interest.

Another thing that initially scared me about the 30 year loan is that I would end up paying around $216k worth of interest alone! But through this example, it should be clear that paying that extra interest is easily worth it if you get serious about investing the difference between what you would have spent in the 15 year loan and the 30 year loan.