Fixed Rate Mortgage: 15 year or 30 year Mortgage?

I recently read an article at Finance is Personal entitled Why You Shouldn’t Get A 30 Year Mortgage. It presents a great argument for why one should get a 15 year mortgage and not a 30 year mortgage – you pay fewer dollars in the long run because of the lower interest rate and fewer years to accrue interest.

However, Matthew, the author of the article, neglected to take interest into account in his comparison of mortgages, so I started running the numbers. I went to Bankrate.com and found that the current average rate for a 15 year loan is 5.91% and a 30 year loan is 6.23%. Let’s assume also that we’re getting a \$200,000 loan and that, over the next 30 years, inflation will happen at a rate of 4% a year.

For the 15 year loan, you’ll make a monthly payment of \$1,678.00 each month for 15 years. If you just directly add up the dollar amount of the payments without worrying about inflation, the total of your payments would be \$302,040.00.

For the 30 year loan, you’ll make a payment of \$1,228.83 each year for 30 years. If you just directly add up the dollar amount of the payments without worrying about inflation, the total of your payments would be \$442,378.80.

So, on the surface, it looks like the 15 year mortgage is a far better deal, saving you \$140,338.80. But there’s a big flaw with that number: if inflation goes up every year, the dollars you spend in the early years of the mortgage are worth far more than the dollars at the end of the mortgage.

Let’s look at the loan entirely in today’s dollars and assume inflation will be 4% from here on out. This means that for the first year, each dollar you pay is worth that same \$1 in today’s dollars, but next year, each dollar will be worth only \$0.96 in today’s dollars. In the final year of the thirty year mortgage, each dollar you pay on the bill will only be worth \$0.32 in today’s dollars.

What’s the final result? The fifteen year fixed rate mortgage is still cheaper, but by much less than before. In today’s dollars, the total you would pay for the 15 year mortgage is \$232,835.04, while you would pay \$265,187.14 for the 30 year mortgage, a difference of \$32,352.10. While significant, it is not the stunning difference that appears when you don’t take inflation into account.

In fact, if you believe inflation is going to be higher than 4%, a 30 year can actually be a better deal. With today’s interest rates on the 15 and 30 year fixed rate mortgages, the 30 year mortgage is actually cheaper than the 15 year mortgage if inflation averages 7% (or higher) a year over the next 30 years. It only takes a few years of Jimmy Carter-esque stagflation to see inflation skyrocket far above that, and some people believe inflation may already be that high from the perspective of the lower middle class where items like gasoline play a large part in the monthly budget.

What’s the moral of the story? Inflation sometimes tells a different tale than you might initially think. Using it here, it’s pretty clear that a 30 year mortgage isn’t nearly as bad of a deal as some might make it out to be – and it might even be a good one.