How many times have you heard something like the following? “On a $250,000 mortgage at 3.5%, if you choose a 20-year amortization instead of 30 years, your payments will only be $328 more per month more and your savings over the life of the mortgage will be $55,675!” This is just well-meaning nonsense.
If there were no such thing as inflation, the figures above would be accurate. But in what universe does is make sense to simply add 2012 dollars to dollars from the year 2042? Even if inflation is only 2.5%, the 2042 dollars will be worth less than half of present day dollars.
To figure out the real savings, you have to take into account inflation. Suppose that over the life of the mortgage, inflation is 2.5%. Then we can take the present value of the 20 or 30 years of monthly payments to figure out the potential savings.
30-year case:
Monthly payment: $1119.09
Present value: $284,281
20-year case:
Monthly payment: $1446.66
Present value: $273,713
The actual savings from choosing the shorter amortization and higher payments is $10,568. I’d rather have this money in my pocket than give it to a bank, but this is a far cry from the figure of $55,675 when we ignore inflation.
I think the people who quote the fictitious huge savings generally mean well, but the reasons why it is usually a good idea to take a shorter amortization go beyond the modest cash savings. If you take a short amortization, the higher monthly payments will steer you towards a more modest home. And the higher payments will dampen lifestyle inflation. You’ll also have more room to lower payments later if your income drops for some reason.
Hi Michael, good post.
ReplyDeleteIt only makes sense to consider the time value of money, but not everyone knows this principle. I imagine the advertisers are just preying on this lack of knowledge.
@Chris B: Thanks. In most cases I think it is well-meaning people who exaggerate the benefits of paying off mortgages faster to convince people to do what is in their interests. I prefer to try to persuade people with real reasons rather than made-up reasons.
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