What type of mortgage loan makes sense when planning to pay it off early?

Question

We are looking for a house, a reasonable one--not outside our means, and planning on paying off our mortgage early. We will have a decent down payment, but keeping some cash for emergencies, and will pay extra principal to pay it off as soon as we can. My question is around the best type of loan for this and things like points. We are of course requiring no early repayment penalties but so far all lenders we've looked at seem to do this already.

It seems that with the 15 year loan, the interest is more evenly spread out, whereas for the 30 year loan the interest is more front-loaded. In other words, your monthly payments at the start go more towards interest than principal and that shifts to more principal and less interest later on. This makes me think that a 15 year mortgage makes more sense since we will be "cutting off" more interest since we plan on repaying early and the interest is relatively more shifted towards the end of the loan. I haven't looked into 10 year term, I wonder if that skews even more towards principal early on... With the current economy I am a bit leery of going so far as an ARM.

Also, buying points at the start lowers the monthly payment and interest, allowing us to apply even more to the principal. I've read that if you aren't planning on paying for the entire length of the loan, points don't make sense. I think I understand this, the up-front cost of the points may not outweigh the saved interest over the life of the loan. Does this still apply if repaying early, maybe even more applicable? For the numbers I'm looking at I'm not so sure.

What I'm looking at for a $400k loan are 3.9% with $18k in points versus 5.6% with no points for a 15 year, and 4.7% with $18k in points versus 6.1% with no points for a 30 year. We can afford the points, it's not a huge percentage of the emergency fund. We are hoping to pay it off in 7-10 years, which math suggests is doable looking at our financial I/O. We should be able to pay up to about $6500 per month, which is after expenses, so 2x the monthly payments or more. We have some buffer even with the higher payments of the 15 year loan.

So does it make sense to do 15 over 30 (is this a dumb question?), and what about points? Are there other options to consider loan wise (i.e. not stocks) when planning to repay early?

Update 1:

Well, I did my own math, which might be wrong, but it seems like points makes sense every time ($4000/mo payment):

Loan: $900000 for 15 years at 4%, $18000 in points
    Total term: 122 months (10 years 2 months)
    Total paid: $506000.00
    Total interest: $87369.49
Loan: $900000 for 15 years at 5.75%
    Total term: 137 months (11 years 5 months)
    Total paid: $548000.00
    Total interest: $145855.71
Loan: $900000 for 15 years at 6.125%, $2900 in credits
    Total term: 141 months (11 years 9 months)
    Total paid: $561100.00
    Total interest: $161129.30
Loan: $900000 for 30 years at 4.75%, $18100 in points
    Total term: 128 months (10 years 8 months)
    Total paid: $530100.00
    Total interest: $110218.54
Loan: $900000 for 30 years at 6.125%
    Total term: 141 months (11 years 9 months)
    Total paid: $564000.00
    Total interest: $161129.30
Loan: $900000 for 30 years at 7.125%, $11000 in credits
    Total term: 153 months (12 years 9 months)
    Total paid: $601000.00
    Total interest: $208647.07

Answer 1

The best mortgage you can get is the one with the lowest APR (which takes closing costs and points into account) that you can afford. Loans with shorter terms tend to have lower interest rates, so the shortest term mortgage that you can afford would be best.

Generally, points are not worth it if you plan to pay off the loan early, since you get less of the benefit of lower interest. In your case, you're saving about $550 (400k * (5.6%-3.90%)), and you'll break even on point in about three years, so if you plan on staying in the house that long, you'll save money in the long run.

The alternative would be to just borrow $18,000 less, which would lower your monthly payment by about $150, so paying points upfront effectively reduces your interest cost by $400 per month.

Since 15-year mortgages have lower interest rates, if you can afford a 15 then that's the best move financially. If you can afford the points and the APR is significantly lower, then it's probably worth it to pay points as well.

I would not dip into my emergency fund or retirement to pay points, though. The savings is probably not worth the lower liquidity.

Note that the interest portion of your monthly payment is always calculated as the principal balance times the monthly interest rate (the annual rate divided by 12), but with a 15 year mortgage the payment amount is higher, so you're paying more to principal and the relative amount going to interest is lower. If you pay off a 30 year mortgage with the same payment amount as a 15-year at the same rate, then the amount going to interest would be exactly the same. All that to say that the main benefit of a 15-year mortgage is the lower interest rate.

Answer 2

It seems that with the 15 year loan, the interest is more evenly spread out, whereas for the 30 year loan the interest is more front-loaded.

It looks so on the first glance.

The truth is that each payment goes to interest first, and the remainder goes to principal.

In the first payment, the interest is the same. Let's say it is $100, no matter if you pay $500 or $1000 a month.

In the next payment, it already makes a difference: in one case, the principal is decreased by $400, in the other case by $900.

With a smaller monthly payment, the percentage of principal of it is higher.

In other words, your monthly payments at the start go more towards interest than principal and that shifts to more principal and less interest later on. This makes me think that a 15 year mortgage makes more sense since we will be "cutting off" more interest since we plan on repaying early and the interest is relatively more shifted towards the end of the loan.

This only seems so. The interest at the end is smaller because the remaining principal is smaller.

The only advantage of a shorter mortgage is that you have a higher monthly rate payment which makes your principal decrease faster.

But that is actually an advantage.

So does it make sense to do 15 over 30 (is this a dumb question?),

Yes, it actually makes sense: the faster you pay your loan off, the less interest you pay.

and what about points?

I don't know about them.

Answer 3

One option is to look for a mortgage that has no penalty fees for over-payment or early repayment. That way, you can make the regular monthly payments, and these should be easily affordable if you have picked an appropriate repayment period.

Then, whenever you find yourself with spare cash building up, you make an over-payment on the mortgage. Eventually, you will get to the point where you can pay off whatever is left in one large payment.

This has the advantage over taking a very short mortgage that if your personal circumstances change, you haven't stuck yourself with large monthly payments that you can no longer afford.

Answer 4

I was in this position, and my strategy was to get the lowest short term interest rate I could.

That was a 7/1 ARM. I'm about to pay off my mortgage and I think I made the right choice though I didn't look at all the numbers closely. My goal was to pay off the mortgage within 7 years.

Answer 5

When trying to decide between with points and without points, in my experience of running the numbers it typically takes about 4-8 years to make the points worth it. (You can always run your numbers to find the exact amount of time.) The example numbers in your update all show a payoff period of more than 10 years, so it makes sense that points would mathematically win without considering other factors.

(You can probably guess where this answer is headed...)

So yeah: Don't buy the points.

Points only make sense if you keep that exact loan for that long. There are multiple reasons you might not keep that loan:

1. Rates have doubled in the last year, and are currently the highest they've been in years. They might continue to go up, but it's pretty unlikely that they won't dip below where they are now in the next, say, 4-8 years which is how long it would take for points to pay themselves back. As soon as rates drop you'll want to refinance, regardless of whether you paid the points since it'll be a sunk cost.
2. Due to job changes, or life changes, you might move before the points pay themselves back. Once you sell your home the loan is gone and the points have no value.
3. If you start making bigger monthly payments, because you can, it takes longer for the points to become worth it. Even in your example you calculated based on $4k/month, but in your question you mentioned you could probably afford paying $6500/month, and that could drastically skew the numbers. If your income increases a few years from now and you bump up your monthly payment even more, the points will have even less value in the long run.

Also, I want to highlight a point from D Stanley's answer which is if you don't buy the points you can put that $18k towards the down payment and reduce your amount borrowed by that amount. This will further reduce the total interest paid when you don't buy the points.

Side Note: I want to reiterate a point from glglgl's answer regarding your statement that the shorter loan seems like it is less front loaded with interest. It definitely seems that way when you look at the amortization table, but the only reason the amount of interest falls at a faster rate is because your interest rate is lower, and your principal paid per month is higher. If the rates on the 15 year and 30 year were identical, I would personally always take the 30 year, and pay as much over the minimum as I could. If you pay enough over that it matches the would-be 15 year payment, then you are achieving the 15 year amortization schedule exactly. If you can pay more than that then you'll pay even less total interest overall. The reason I would always prefer the 30 year over the 15 year if the rates were equal is because I like having the option to make smaller payments if I ever wanted to at some point in the future. However, in my experience the 15 year option has always had the lower interest rate, so I have gone with the 15 for that reason alone.

Final Thought: I purchased a home 5 years ago and refinanced it twice since then. Thankfully, I had the option of choosing no cost refinances, so I didn't even pay closing costs. Any closing costs, like buying points, are a sunk cost that makes it not worth refinancing for X amount of months. In my case when rates were dropping month over month, with no cost refis I could have theoretically refinanced every couple of months, and it would have made financial sense to do so. The only reason I didn't was out of respect to my mortgage broker who requested I waited 6 months before refinancing (or else he would have to repay his commission). On my last refi my broker called me one day after the 6 months was up and told me to submit my application ASAP. That one took me from 3% down to 2.5% and I suspect I won't be refinancing again anytime soon. I wouldn't feel that way though if I were sitting on a 4% loan or higher.

Answer 6

You have 5 decent answers so far. I'd like to challenge the premise of the path you are on.

With such a high income (implied by having $6500 to pay towards the mortgage) you are probably in a relatively high tax bracket, and itemize. The mortgage interest is therefore a deduction. Not a reason to have debt, but it makes the cost, the interest rate, about 25% lower.

I recommend reading another question here, "Oversimplify it for me: the correct order of investing". It offers a look at how members would prioritize paying off debt, vs investing.

Consider that in any 15 year period, the S&P has never been negative. I created a spreadsheet to look at the 15 year rolling returns of the S&P from 1900-2018, and found - Average 10% return. 12 periods were under 5%, and only 5 of those were under 4%. In other words, if your after tax cost of money is 4% or less, you have a 95% chance of being ahead, by paying the minimum and investing the difference. If a bit behind at year 15, the next 15 make up for it.

Last - keep in mind, if rates keep rising. You may have the option of putting the cash into guaranteed Treasuries at a higher rate than your mortgage. If rates drop, you can refinance. I started with a 30 year 7.625% mortgage in 1996, and after multiple refinances, retired with a 15 year term at 3.5%. Which will be paid off at the same 30 year mark. At year 15, the investments were nearly twice the mortgage balance, no regrets.