Maximize Your Mortgage: Choosing the Optimal Loan Terms for Your Wealth Journey

8/25/2020

After completing two home purchases and two refinances over the past 10 years, my husband and I are no stranger to the mortgage lending process. One of the biggest decisions we had to make during each transaction was the duration and terms of each loan. When it comes to taking on large sums of debt, you want to make sure you evaluate your options from all angles. The best option may not always be the most attractive one at face value.

Today I’ll outline my experience with three different types of loans:

10/1 ARM

30-year fixed-rate mortgage

15-year fixed-rate mortgage

Each of these loans met various needs and criteria that we had during the time of each of our transactions so I will walk you through our thought process and what items to consider. Let’s go!

Adjustable-Rate Mortgage (ARM)

Adjustable-rate mortgages (ARM’s) are mortgages that offer a fixed interest rate for a specified period of time (typically, 5, 7 or 10 years) and then adjust periodically (such as yearly) for the duration of the loan. Interest rates can increase or decrease based on a benchmark interest rate index that is chosen by the lender. The full term of an ARM is usually 15 or 30 years.

There are several ways these loans are structured, which are expressed by the duration of the fixed and variable time frames. A 5/1 ARM, for example, has a fixed interest rate for 5 years and a variable rate that resets every year thereafter for the duration of the loan.

ARM’s typically, but not always, have lower interest rates for the fixed portion of the loan in comparison to traditional 15 and 30-year fixed-rate mortgages. Therefore, if you do not plan to live in your home longer than the duration of the fixed interest rate, an ARM is an ideal option that can save you money in paid interest.

When we bought our first condo, we knew we would eventually want to upgrade to a single-family home in the future, so we opted for a 10/1 ARM with a 30-year term. At the time, this loan offered a notably lower interest rate in comparison to a traditional 30-year fixed-rate loan. Even though we had the option to choose a 5/1 or 7/1 ARM at an even lower interest rate, we felt a 10/1 ARM gave us an added buffer in case our circumstances changed.

When we did make the move to a single-family home a few years later, interest rates between a 10/1 ARM and a 30-year fixed rate were almost equivalent. Although we were not certain that we would stay in our new home long-term either, a traditional 30-year loan provided additional security without sacrificing a significantly higher cost in interest.

When evaluating an ARM, you’ll want to consider the following:

How long do you realistically think you will live in your home?
What is the difference in interest rates between the ARM offerings and fixed rate?
Does the cost savings between an ARM and fixed-rate loan justify the benefits of securing a fixed-rate loan?
How much of a time buffer do you want to give yourself in case you own the home longer than expected?

With more companies moving towards remote work, plenty of geo-arbitrage opportunities to relocate to lower cost of living areas, and increased connectivity, finding a forever home is not always the end goal anymore. The average home buyer now lives in their home for 8 years.

ARM’s have the potential to provide significant savings in comparison to their fixed-rate counterparts for shorter-term residencies.

30-Year Fixed-Rate Loan

A 30-year fixed-rate loans is the most common loan for new purchases and refinances. Compared to a 15-year loan, 30-year loans typically demand higher interest rates but offer lower monthly payments.

When homebuyers are evaluating 15 vs. 30-year loans, there are usually three considerations:

What is the total cost of each loan (principal + interest)?
What monthly payment can I afford?
How quickly do I want to pay off the loan?

Although the total cost of a 30-year loan is higher than a 15-year loan, the lower monthly payment reduces the risk of being over leveraged during difficult times.

When we decided to refinance our home a second time after interest rates plunged to all-time lows in 2020, we switched from our 15-year loan to a 30-year loan to lower our monthly obligation. If there is one thing you want to protect in uncertain times, it’s the place you have shelter.

30-year fixed rate loans also offer two other added benefits in low-interest rate environments:

1. Hedge Against Inflation

Inflation might not be the first thing that crosses your mind when considering a loan, but over time it can have a significant impact on the long-term value of a loan.

The average annual inflation rate over the past 10 years has been ~2%, which means that the value of a US dollar has decreased by ~2% each year. Therefore when you take a fixed-rate loan, you are essentially paying off your loan with "cheaper" dollars over time. A monthly payment of $1,000 for a 30-year loan today will feel like much less in the future.

As wages increase with inflation, the percentage of income going towards your monthly payment also decreases. The longer the duration of the loan, the more purchasing power you have with your remaining income over time.

2. Opportunity Cost

When you are considering different loan options, you will also want to look at the opportunity cost of different loan offerings given the interest rates and required monthly payments. Low-interest rates provide an opportunity to pair low-interest debt with higher market returns.

Let’s say for example that you have the following options for a $100,000 loan:

15-year loan at 2.5% interest
- Monthly Payment: $666.79/month
- Total Loan Cost (Principal + Interest) : $120,021.98
30-year loan at 3.00% interest
- Monthly Payment: $421.60/month
- Total Loan Cost (Principal + Interest) : $151,778.36

Assuming you can afford the higher monthly payment, the 15-year loan looks optimal given that you will be paying $31,756.38 less in total interest ($151,778.36 - $120,021.98).

Let’s say instead though, you opt for the 30-year loan. Each month you take the difference between your monthly payment and what you would have paid on a monthly basis for a 15-year loan ($245.19) and invest it in the market for 15 years for an average annual return of 5%. At the end of 15 years, you now have $63,999.91.

Now let’s look at cost of each loan again given the market returns you earned using a 30-year loan:

15-year loan at 2.5% interest
- Total Loan Cost: $120,021.98
- Market Return: $0
- Net Cost: $120,021.98
30-year loan at 3.00% interest
- Total Loan Cost: $151,778.36
- Market Return: $63.999.91
- Net Cost (Total Loan Cost - Market Return): $87,778.45

Even though you pay a higher amount of interest for a 30-year loan, your market gains in this example offset the total cost by $32,243.53.

A $32,243.53 savings in this scenario is a great reason to opt for a 30-year loan and leverage higher market returns. Of course, markets do not grow in a perfectly linear fashion so there is always some inherent risk that your average returns may be lower than the interest paid.

If you are in a wealth-building phase and can manage a potential loss of your investments, the benefits of earning a sizable gain may outweigh the risks.

The opportunity cost of taking a low-interest 30-year loan was one of the main reasons we refinanced from our previous 15-year loan to our current 30-year loan. Since we had no immediate need for the additional income by reducing our monthly payment, we are investing the difference in a diversified portfolio through Wealthfront instead to earn higher market returns.

Before you snag a 15-year loan, calculate the opportunity cost using this analysis first with your own loan amount and interest rates available to you. You can use the following resources:

Vertex42 Home Mortgage Calculator - this is my favorite mortgage calculator to evaluate my estimated monthly payments and interest payment schedule.

Compound Interest Calculator - this is a quick and easy calculator to forecast future market returns.

15-Year Fixed-Rate Loan

15-year fixed-rate loans are an optimal option if you want to pay off your debt and can afford a higher monthly payment. There is no better feeling than owning a home and being debt-free!

15-year loans are a good option to consider when you find yourself in the following situations:

You want to protect your wealth

In the previous example, I demonstrated how the total cost of a 30-year loan could be cheaper than a 15-year loan by offsetting the cost with higher market returns.

This strategy however comes with some level of risk. If you are trying to protect vs, grow your wealth, paying off your debts at a lower cost and as soon as possible is a more ideal option.

You don’t think you can beat the interest rate with higher market returns

In 2019, we opted for a 15-year loan refinance when interest rates dropped below our existing 30-year loan. Although we could have never predicted the pandemic we are in today, there were signs indicating that a recession was potentially on the horizon.

Not knowing if we would stay in our house beyond a few more years, we were not overly confident that our market returns could beat the interest rates offered for a 30-year loan on the market in that period of time. So we opted for a 15-year loan instead.

Lower interest rates increase your chances of generating higher market returns using a 30-year loan as shown previously, however your strategy is dependent on what investments you choose and how much risk they come with.

Don’t Take a Good Interest Rate for Granted

Despite many financial headwinds that Millennials have faced in their professional careers, one of the silver linings that we’ve had access to is low-interest debt. Even during one of the strongest bull markets in history, the average 30-year mortgage interest remained at or below 5%.

Given that most of us were too young to purchase a home in prior decades, it’s harder to appreciate how much cheaper mortgages have been in our adult years compared to what former generations had to pay.

During this time of economic recovery, the Fed has committed to keeping interest rates low until 2022. Since then, mortgage rates have continued to drop since the COVID-19 pandemic.

While it’s unlikely that interest rates will suddenly skyrocket beyond this time frame, it’s good to keep in mind that interest rates do have the potential to rise again over time. Therefore the next two years is an optimal time to consider a home purchase or refinance if you have the means to do so.

Each loan type can provide some unique opportunities to build your capital, particularly in a low-interest rate environment. In times like these, you can begin to incorporate more strategic wealth-building strategies using low-interest debt. Therefore, you’ll want to think about where you are in your wealth-building journey when buying or refinancing a home.

Before making a home purchase or refinance, consider how a new loan fits into your long-term financial picture and what tactics you can use to save potentially thousands of dollars and boost your wealth.

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