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15 or 30-year mortgage? How about something different?

June 4, 2022

30-year fixed-rate mortgages are a workhorse of the American dream of homeownership, but the average length of stay is only ~10 years. So, why do people pick a term of 30-years? The obvious answer is affordability. 90% of home purchases are financed with a 30-year mortgage, whereas the 15-year mortgage is primarily used for refinancing when balances are low.

The 15 vs. 30yr mortgage argument offers several pros and cons for each side but is a false dichotomy that oversimplifies consumer choices into two buckets. This argument represents an informal fallacy where the inference is valid, but the premise is not. Indeed, most of us cannot afford a 15-year mortgage payment, especially with high-interest rates (~5%) and explosive growth (~19% in 2021) in home prices. However, the oversimplification of choice, 15 or 30-year term is the false premise.

20-year and 25-year mortgages are also viable alternatives. In fact, mortgages can be amortized to any term and are not limited to discrete 5-year increments. While your mortgage lender may not offer a 22-year mortgage, you can customize a 30-year mortgage to any length by altering your payment schedule. Customization can occur on any existing mortgage and does not require a refinance. Before customizing a mortgage, let's understand how amortization works and what happens to a mortgage in the secondary market.

To "amortize" means "to kill, slowly," i.e., the loan is repaid slowly over time. Four things are true in mortgage amortization. The first two are common sense, but the second two may surprise you!

  1. Monthly payments are fixed for the life of the loan, duh!
  2. The loan balance goes to zero over the duration (i.e., 30 years), duh!!.
  3. Mortgages use simple interest - Interest never compounds, and simple interest is paid every month on the entire loan. A $500k loan at 3% would owe $1250 in month one interest (3/12 = 0.25% x 500k)
  4. The proportion of principal and interest in each monthly payment is unique and sensitive to two factors: interest rate and loan length

Many lenders only offer 15 or 30-year terms because of common standards in the secondary mortgage market. The primary mortgage market refers to consumer, broker and lender interactions of application, processing, underwriting, and funding. In the background (i.e. the secondary market) most mortgages are sold to Fannie-Mae and Freddie Mac (two government-sponsored enterprises or GSEs), who package and sell them to investors. A mortgage is like a bond, where mortgage investors receive predictable payments for a fixed time. The word "conventional" describes a mortgage sold to Freddie or Fannie. These two GSEs are vital in introducing financial liquidity into mortgage markets. The US mortgage market is worth $12T, but banks have less than $1.5T in depositor money. Therefore, only 12-13% of outstanding mortgages could be funded by banks without access to the secondary market.  

"The secondary market structure makes getting a mortgage of non-standard length more difficult, but the nature of amortization allows customization to any length." Framed differently, you can either take a 22-year mortgage and pay the minimum monthly payment or take a 30-year mortgage and make the 22-year payment. In either scenario, the mortgage will end in 22-years and will cost you the same.

Another enabler is the new regulation under Dodd-Frank, specifically Title XIV: Mortgage reform and anti-predatory lending act, which eliminated (most) pre-payment penalties. As a result, customizing mortgage length is now a genuinely free "call" option to pay a small portion of your mortgage every month. Hopefully, we've helped debunk the faulty premise of two mortgage term choices (15 or 30), which raises the fundamental question: how long should my mortgage be?

The decision of mortgage length could be as unique as the home you buy. It's a trade-off between the monthly affordability in the short term and interest payments in the long term. Investing extra cash flows into your monthly mortgage payment has opportunity costs, but also offers a guaranteed return and is tax-efficient. Managing your largest debt should not be left to the vagaries of mortgage lenders and the secondary market structure. Altgage offers customized mortgage payment plans that minimize the impact on monthly affordability and maximize the reduction in interest expense. Net wealth is the difference between assets and liabilities. Homeowners will be better off by avoiding the status quo of the 30-year fixed-rate mortgage.

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