The Effects of Income Tax Rates and Interest Rates in Choosing between 15- and 30-Year Mortgages

By Vruwink, David R.; Fisher, Dann G. | The CPA Journal, November 1995 | Go to article overview

The Effects of Income Tax Rates and Interest Rates in Choosing between 15- and 30-Year Mortgages


Vruwink, David R., Fisher, Dann G., The CPA Journal


For most people, the most significant investment decision they will make in their lifetime is the type of home they will purchase. Almost as important is how they will finance that home. A well thought out plan of analyzing their future financial needs when financing that home could have a meaningful impact on their standard of living.

A choice between 15- and 30-year mortgages is what most people normally consider. Those people who select the 30-year mortgage usually like the lower monthly payments and the higher tax deduction for interest on the mortgage. The 15-year mortgage is preferred by those people who want to build equity in their home faster and save tens of thousands of dollars in additional payments of interest. Also, the shorter mortgage offers a means of earning a higher return than a savings account and enforces a savings discipline on the homeowner.

Some homeowners could benefit from an analysis of the advantages and disadvantages of 15- and 30-year mortgage taking into account their personal and financial attributes. Such an analysis will provide insight as to how financing the home would affect their financial status later in life.

The Evaluation Process

The two major financial goals of any homeowner in financing a home should be to either 1) have more money to spend or save or 2) have a greater financial net worth at the end of the financing period. If a homeowner needs to minimize his or her mortgage payment because of their limited ability to make higher mortgage payments, the 30-year mortgage is the easy choice. The decision becomes much more complicated when the major goal of the homeowner is to increase his or her own financia net worth.

To determine whether a 15- or 30-year mortgag is best for increasing net worth, the homeowner must focus on four factors: 1) the net cash difference between the 15- and 30-year mortgage, 2) the hurdle rate or earning rate of return on the net cash difference which the homeowner must exceed to be financially better off with the 30-year mortgage, 3) the investment time horizon of the homeowner, and 4) the homeowner's investment strategy to earn a rate of return that exceeds the simple strategy of building equity through a 15-year mortgage.

Net Cash Difference. Since a 30-year mortgage requires lower monthly payments and produces greater tax savings than the 15-year mortgage, a net cash current saving difference results each year. The amount of the cash difference is significantly affected by both the level of interest rates and the homeowner's expected marginal income tax rate over the relevant 15-year financing period. While the homeowner should be able to predict the interest rates he or she will be able to lock in the near future, the marginal tax rate is more difficult to estimate.

Table 1 indicates that the higher the homeowner's marginal income tax rate, the greater the net cash current saving difference between the 15- and 30-year mortgage regardless of interest rate. This outcome occurs because the 30-year mortgage payment has more interest than a 15-year mortgage payment.

Table 1 reading vertically, indicates that as mortgage rates rise, the net cash difference declines for a particular marginal income tax rate. This outcome occurs because, as rates rise, the amount of interest in the 15year mortgage payment increases at a faster rate as compared with the 30-year mortgage payment. The tax deductibility of the mortgage interest somewhat offsets this decline. In other words, the net cash difference declines at a slower rate, the higher the marginal income tax rate of the homeowner increase.

Table 1 has two limitations. First it assumes that a homeowner's expected marginal tax rate will be the same throughout the 15-year financing period. If the homeowner expects a future increase or decrease in the marginal income tax rate, then adjustments have to be made to the numbers shown in Table 1.

Second, the table assumes that marginal tax rate of the homeowner will not change under both the 15- and 30-year mortgage. …

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