Home ownership has changed from the way it used to work for prior generations. Fifty years ago, many people bought a home and stayed in it for 30 years or longer. Far fewer take that approach today. As a result, many past “rules of thumb” need to be reevaluated. The answer to “How should I finance my home purchase?” is, as with so many financial planning questions, “It depends.” From the typical fixed rate mortgage options to adjustable rate mortgages, let’s review the options.

Basic Home Financing Methods

The two most basic financing methods remain the 15-year and the 30-year fixed rate mortgages.

The 15-Year Mortgage

  • Setting up a 15-year mortgage typically results in a meaningfully lower rate of interest on the mortgage. As you own the home over time, you pay less total interest.
  • Few people consider that, in addition, a 15-year mortgage acts as an “enforced savings” line item on your budget. More money has to go to the monthly payment, so your home equity balance accumulates more rapidly. The 15-year mortgage can grow your overall net worth faster.
  • Some people simply prefer to have a paid-off home as soon as possible, so there can be a strong emotional component there. That component cannot be ignored. If having 15 years to pay down a mortgage instead of 30 will help you sleep better, that factor needs to be seriously considered.

The 30-Year Mortgage

  • Setting up a 30-year mortgage offers greater flexibility. With a lower monthly payment, you can choose to pay additional principal any given month, but if an income reduction occurs for any reason in the family, the 30-year mortgage minimizes what has to be paid on the home on a monthly basis.
  • To match the 15-year mortgage in terms of net worth accumulation, the amount saved in monthly payments by using the 30-year mortgage would need to be dedicated to long-term savings.
  • One of the best long-term savings goals to dedicate the monthly mortgage savings to is saving for college. If you save $200 to $500 by using a 30-year mortgage and dedicate that entire amount to a 529 plan when your children are young, you can save for two goals rather than one.
  • Oftentimes, the monthly savings in a 30-year mortgage versus a 15-year mortgage is NOT invested in the long-term investment portfolio to accumulate wealth but instead is spent on living expenses. For some, having more money for monthly expenses is critical, but be careful about buying as much house as you can “afford.” Remember: appliances break, basements flood, and roofs need to be replaced.

Other Mortgage Products

Adjustable Rate Mortgages

Some buyers may choose to use 5-, 7-, or 10-year ARMs (Adjustable Rate Mortgages) to further lower their interest rate and monthly payments. The lower monthly payment simply moves further along the savings path outlined above.

These vehicles are commonly chosen because families do not expect to live in a home beyond the term of the mortgage and want to keep their monthly expense as low as possible. The most significant caveat to consider with these kinds of mortgage is the old adage, “The only thing constant is change.” It is one thing to make a discretionary decision to minimize monthly payment with the capacity to pay more. It is another to utilize a low-rate product because it is the only way you can afford a home.

Stretching your budget to capacity and beyond leaves you vulnerable to multiple risks:

  • The value of the home may go down, making selling the home difficult to impossible. Remember, when you sell the home, you should have at least sufficient equity to cover the 6%+ selling costs and related taxes.
  • Your plans may change, and your need to stay in the home may extend beyond the term of the mortgage.
  • Interest rates may increase, leaving you with much higher monthly payments when you either move to the adjustable rate portion of the mortgage or refinance to a new mortgage.
  • You are likely to accumulate far less equity in the home (or no equity at all if you utilize an “Interest Only” mortgage), reducing or eliminating the financial moat that would otherwise accumulate on the home that could assist with downside shocks.
  • You may relocate to a higher cost area of the country and find yourself wishing you had accumulated more equity in order to make the down payment on the new home.

Paying Off the Home vs. Interest Rates

These days, with very few people staying in a home for the full term of the mortgage, the choice of how to finance is less about paying off the home and more about structuring monthly expenses, designing long-term savings, and balancing multiple aspects of financial planning.

Even for families who can afford to pay cash for a home, financing the purchase can make sense. Homes typically appreciate in value over time – albeit slowly, and with the risk so many homeowners experienced in the last decade that they can go down in value. Homes are unique assets, though, in that banks will give sizable loans at attractive rates on which the government then offers tax deductions (mortgages created after 12/15/2017 can deduct interest on up to $750,000 of debt).

With long-term mortgage rates still below 4.5% (and below 4% on an after-tax basis for many), if a long-term investment portfolio can earn 6-7% in returns over a 15-year time period, then financing the home can be a favorable choice. This financial planning strategy only became viable when interest rates dropped. Many people adamant about “getting out of debt” on their home remain strongly influenced by parents’ and grandparents’ experiences with paying 8%, 10%, or even 16% on their mortgages. Very different math!

These days, with very few people staying in a home for the full term of the mortgage, the choice of how to finance is less about paying off the home and more about structuring monthly expenses, designing long-term savings, and balancing multiple aspects of financial planning. We believe working with a fiduciary who has the experience and expertise across a breadth of many unique situations (and who is providing you advice based on your best interests) can provide valuable insight to your particular needs.

This update has been provided for informational purposes only and should not be construed as individual investment or tax advice. Please contact your investment and/or tax professional(s) to discuss your personal situation.

Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, Certified Financial Planner™ and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.

Author Joel Cundick Financial Advisor / Team Lead

Joel is frequently quoted in local and national media and has been a repeat guest on Federal News Radio. He teaches retirement preparation seminars to Federal employees through the National Institute of Transition Planning.

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