…And now, the rest of the story… Part II

I received lots of interesting feedback from last week’s post about the 30 year mortgage versus the biweekly mortgage.  The most common theme expressed was that people will never do it.  People wouldn't have the discipline to save the extra amount each month.

True enough.  But if someone was paying a biweekly mortgage, chances are they would have those payments drawn automatically from a bank account.

To make the 30 year mortgage work, that person would simply have to have the extra savings drawn automatically.

One piece where people can have a hard time is the saving of the extra tax costs.  Remember that as that couple would have paid less in interest, they would have paid more in taxes.  Calculating what their tax liability versus what it would have been would take some work.

That same couple highlighted last week also had another option to finance their house – the 15 year mortgage.  Again, they liked paying less in interest and paying off their house sooner.

Once again, we’ll use the same article about mortgage to provide the numbers and use the same steps I showed last week.

Let’s take the figures from the mortgage article.

30 Yr Mortgage Interest	$177,762.87
15 Yr Mortgage Interest	$64,147.51
Savings	$113,615.36

But if you compare interest at the 15 year mark, the figures are as follows:

30 Yr Interest	$126,062.15
15 Yr Interest	$64,147.51
Savings	$61,914.64

Just like last week, there’s more…

Let’s account for the extra taxes the 15 year mortgage payment would cause.

Assuming you are in the 25% tax bracket, here’s what the savings really looks like:

30 Yr Interest	$126,062.15
15 Yr interest	$64,147.15
Savings	$61,914.64
Less: Increased taxes	($15,478.66)
Net savings after taxes	$46,435.98

And now, let’s account for the opportunity costs of those extra tax payments.

Using an assumed 7% pre-tax, here’s what the figures now look like:

30 Yr Interest	$126,062.15
15 Yr interest	$64,147.15
Savings	$61,914.64
Less: Increased taxes	($15,478.66)
Net savings after taxes	$46,435.98
Less: Opportunity cost of taxes paid	($6,264.63)
Net savings after taxes and opp costs	$40,171.35

Now, let’s assume that this couple instead saved the extra money that the 15 Yr payment requires versus the 30 year payment.  Each month, that would be $695.92 in savings.

Assuming that same 7% return (pre-tax), after 15 years, the side fund would have $184,566.49 including over $59,000 in after tax interest!

Now, take a look:

30 Yr Interest	$126,062.15
15 Yr interest	$64,147.15
Savings	$61,914.64
Less: Increased taxes	($15,478.66)
Net savings after taxes	$46,435.98
Less: Opportunity cost of taxes paid	($6,264.63)
Net savings after taxes and opp costs	$40,171.35
Less:  Interest earned in side fund	($59,300.89)
Net savings after all items	($19,129.54)

Advantage – Regular mortgage with a side fund (by over $19,000!)

At the end of 15 years, the balances look like this:

Balance of 30 Yr mortgage	$187,180.72
Balance of side fund	$184,566.49
Plus:  balance of tax savings opp cost	$21,743.29
Total available to pay off mortgage	$206,309.78
Net cash after mortgage payoff	$19,129.06

What’s more interesting is the break even interest rate.  After all, no one can guarantee that you will earn 7% per year in this example.

So what’s the break even rate where the side fund and tax effects equal the payoff balance after 15 years?

Answer:  5.1% pre tax.  Lower than the break even when comparing against the biweekly mortgage.

This concept is especially important for anyone whose income varies monthly – such as the highlighted couple where the husband is in technology sales.

Granted, they could have made the higher 15 year payment; my concern was what would happen during a low income month.

My recommendations to them was based on these 2 points:

1. They could still pay their house off early (25+ years like the biweekly, or 15 years like the 15 year mortgage).

2. But they growing side fund afforded them opportunities and provided a cushion in case anything happened with the job, unexpected medical expenses, layoffs, etc.

Ultimately, they decided to go with a 30 year mortgage, but with the savings compared with a biweekly.  Their rationale was that a lower monthly payment and a lower savings amount will be easier on their monthly cash flow.

What do you think of this concept?  Which option would you have gone with?

And you have the rest of the story…