Borrowers grow more wealth with 15-year mortgage

Q: I can afford the larger payment on a 15-year fixed-rate mortgage, but I plan to take a 30-year anyway, invest the difference in the cash flow, and end up ahead. Is there a flaw in this plan?

A: Yes. The flaw is that the investment return required to make the plan work is much too large. You will almost certainly end up poorer than if you take the 15-year mortgage.

If 15-year and 30-year loans carried the same rate, say 6 percent--and you earned 6 percent by investing the difference in monthly payments--you would end up in the same place. Your investment return would have to exceed 6 percent to come out ahead on the 30-year loan.

Assuming 15-year loans carry a lower rate, which is almost always the case, the required return to break even rises. For example, assume the 30-year rate is 6 percent and the 15-year rate is 5.625 percent, a typical rate difference of 0.375 percent. The break-even rate would then be 7 percent over 15 years, 7.86 percent over 10 years, and 10.49 percent over five years. Very few mortgage borrowers today keep their loan for 15 years.

The calculation above assumes the interest rate is the only difference between the two loans. But if the down payment you expect to make is less than 20 percent, you will have to pay for mortgage insurance, and the premiums are higher on the 30-year loan. For example, if you put down only 3 percent and pay standard insurance premiums, the break-even investment rate is 7.49 percent over 15 years, 8.95 percent over 10 years, and 12.78 percent over five years.

All the required returns shown above were calculated from calculator 15b on my Web site.

The upshot is that a strategy of taking a 30-year loan and investing the cash flow difference between that and a 15-year loan is almost bound to be a loser. Even if you are disciplined enough to actually make these monthly investments regularly, it is very unlikely that the return will be high enough to leave you ahead. This is particularly the case if you are not putting 20 percent or more down, and if your time horizon is short.

For those who can afford the payment, the 15-year fixed-rate mortgage is a winner.

Q: My husband and I are purchasing a home, which is not picked out yet. Our Realtor has given us the names of four mortgage companies to work with to get pre-approved. Should we get pre-approved by all four or just pick out one to work with?

A: One lender is all you need, and you may or may not end up working with that lender.

A mortgage pre-approval is the same as an approval in the sense that both involve a check of your finances and your credit. Pre-approval is something less than approval, however, because the property value is preliminary and won't be definitively established until you have a purchase contract. Furthermore, a pre-approval may not specify a mortgage price, and if it does specify a price, it is not binding on the lender.

So what exactly is it? It is a statement of opinion by a lender that a prospective buyer has the income, assets and credit to carry the mortgage required to purchase a house of some assumed value. Since the borrower's mortgage-carrying capacity depends on an interest rate that is not yet known, and since the price of the house is preliminary, a pre-approval has a lot of slack.

It is adequate, however, for the purpose for which it is intended. That purpose is to convince a home seller that a prospective buyer has the means to make the purchase and should therefore be taken seriously.

The only reason for you to obtain a pre-approval is because the owner of the house you want to purchase is looking for you to have one. More than one would serve no purpose.

Why do lenders offer them? Their hope is that the purchaser will view the pre-approval as the first step in obtaining a loan. It is a way of generating a promising lead. But you should not view it that way.

Selecting a lender for no other reason than that the lender had issued you a pre-approval would be a mistake.

On the other hand, there is no reason to exclude that lender from your search for a loan provider. If your experience with the pre-approval was favorable, and if you are having difficulty making a decision among loan providers, you might want to give the lender providing the pre-approval an edge over the others seeking your loan.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.

Copyright 2006 Jack Guttentag