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     Entrepreneur Kurra Bewarse Username: Entrepreneur Post Number: 1391 Registered: 05-2011 Posted From: 24.130.197.214 Rating: N/A |
5 case scenario OK let us take these scenarios: Dinesh wants a 200K loan. Options are 30 year or a 15 year mortgage. We will start with 4.00% interest rate for both the 30 year loan and the 15 year loan for simplicity. Later in case #6 (also case #3), I will take on a more realistic case where interest rate for 15 year loan is lower. CASE 1: Affordability: Payment on 30 year loan will be $954.83 which we round to $955 a month. Payment on a 15 year loan will be $1479.38 which we round to $1479 a month. The difference in 2 payment is 524 a month and if this extra money causes hardship for Dinesh, then the choice is simple and clear that Dinesh must go for a 30 year loan. No tax or other financial considerations matter here. CASE 2: Mental Comfort key and Discipline: Payment on 30 year loan will be $954.83 which we round to $955 a month. Payment on a 15 year loan will be $1479.38 which we round to $1479 a month. 15 year loan monthly payment is $524 per month more than 30 year loan payment. Dinesh can afford the extra payment without concerns of liquidity. Dinesh's critieria is mental comfort and want to pay off the loan. Whenever Dinesh has a loan, even if he has other assets, he does not feel mentally comfortable. Dinesh is a disciplined person. In this case, the approach suggested by member Old Spice in this post makes sense. Selection here is 30 year loan but keep making the extra payments. CASE 3: Mental Comfort key and Discipline and 15 year interest rate is better than 30 year case: Interest rate on 30 year loan X%. Interest rate on a 15 year loans is less than X% (how less is immaterial). Dinesh can afford the extra payment without concerns of liquidity. Dinesh's critieria is mental comfort and want to pay off the loan. Whenever Dinesh has a loan, even if he has other assets, he does not feel mentally comfortable. Dinesh is a disciplined person. Dinesh is going to pay off the loan in 15 years even if he has a 30 year loan by making extra payments, but in above case locking himself to 15 years gets him a lower interest rate and thus saves him some money to boot, so in that case selecting 15 year loan makes the most sense. CASE 4: Mental Comfort key but not disciplined to make extra payments on schedule: Payment on 30 year loan will be $954.83 which we round to $955 a month. Payment on a 15 year loan will be $1479.38 which we round to $1479 a month. 15 year loan monthly payment is $524 per month more than 30 year loan payment. Dinesh can afford the extra payment without concerns of liquidity. Dinesh's critieria is mental comfort and want to pay off the loan. Whenever Dinesh has a loan, even if he has other assets, he does not feel mentally comfortable. Because Dinesh is not disciplined and he may use the excess money for some other extravagances, it is best that he lock himself into a 15 year loan and hence select 15 year loan. CASE 5: Financial Criteria key - Mental Comfort comes to Dinesh from knowing he is making financially sound decisons: Payment on 30 year loan will be $954.83 which we round to $955 a month. Payment on a 15 year loan will be $1479.38 which we round to $1479 a month. 15 year loan monthly payment is $524 per month more than 30 year loan payment. Dinesh can afford the extra payment without concerns of liquidity. Dinesh is disciplined to develop an AAP and DCAs $524 every month into an investment plan for the next 15 years. He is willing to take some risk in equities and forgo the risk free repayment of principal in favor of long term investments. He is willing to adjust the AAP to lower risk every year as years go by and at the end of 15 years take the money out and payoff the remaining mortgage with it. With this approach, while there is some risk, there is a high degree of probability that Dinesh will have money left over after 15 years after paying of the remaining mortgage balance. So in this case, the mortgage choice is a 30 year loan. ========================= Now a more REALISTIC scenario where the interest rate on a 15 year loan is lower by at least 0.2% than on a 30 year loan. CASE 6: Financial Criteria key - Mental Comfort comes to Dinesh from knowing he is making financially sound decisons: Interest rate on 30 year loan = 4.00% Interest rate on 15 year loan = 3.70% (check bankrate.com or other sites for actual interest rate differential) Payment on 30 year loan will be $954.83 which we round to $955 a month. Payment on a 15 year loan will be $1449.49 which we round to $1450 a month. 15 year loan monthly payment is $495 per month more than 30 year loan payment. Dinesh can afford the extra payment without concerns of liquidity. Since Dinesh is comparing choices, his one choice is 30 year loan a 4% interest. Should Dinesh decide to go with 15 year loan, he has to pay $495 more per month towards principal. This means he is saving the 4% interest on that money if we are comparing to 30 year case. In addition to saving that 4% on his principal repayment, by selecting to pay extra $495 per month towards principal, he also gets 0.3% (4.00% minus 3.70%) interest savings on the entire loan amount >> 0.3% of 200,000 is $600 or $50 a month. $50 return on the $495 on top of the 4% return all in just one month looks fantastic but is a bit deceiving. Next month the savings will still be $50 approximately, but his outlay would be 495 times 2. So it turns out that during the first year, extra principal contributed is approximately $6643. And savings in interest the first year are 707. This looks like a 10.6% return but since all of the 6643 payment is not made during first month but distributed throught the year, it is more like a 15% return. This shrinks to about 9% or so the next year and somewhat lower the next and so on till the saving is only 4% the final year. And all this is risk free return. To me, this is great return. In this case, the choice is clearly 15 year loan. If the interest rate differential is smaller than 0.2%, then it becomes like case #5 to me and I would in that case be willing to risk some and follow suggestions in case #5. If the differential in interest rates is 0.2% or greater, I would go for a 15 year loan. Of course some calculations on the return in case 6 are approximations. I could have done a cash flow analysis but that would be more time consuming, so I did more like a back of the envelople calcs. |