When comparing loan options, the bottom line might surprise you
As described in the December 2019 article, I worked with Dr. John Abernathy, Accounting Professor at Kennesaw State University to create a tool to calculate how inflation impacts compound interest. It is reasonable that when entertaining financing a property, one looks at interest and how much they might be forced to pay over time. After all, we have been taught how bad “debt” is and how we must get out of it as quickly as possible.
We have already discussed the nullification of the compound interest over time, so now let’s look at how that compares to a shorter term with a visibly lower dollar-for-dollar expense. The argument is the 15-year must be better with interest being charged over a shorter period, fewer dollars being paid out in the form of interest, therefore outperforming the interest period that one is subject to for a longer timeframe. Why would this not be logical and why is there even the slightest argument to the contrary? This would be a very elementary conclusion; however, we must consider our inflationary environment when thinking anything paid over time.
Let’s consider a 15-year fixed rate mortgage using the same principle loan amount in previous examples of $83,960.00. The borrower will be repaying the principal plus $33,529.18 in interest for a total of $117,552.18 in collective payments over 15 years. With the same loan amount for the 30-year, $73,711.04 would be paid in interest on the same principle amount resulting in $157, 671.04 in total Principal and Interest (P&I) repayment. Simple math shows that the borrower will pay significantly less in actual dollars on the shorter-term loan. There is a catch, however. Inflation.
At a five percent inflation rate, we are (with the help of Dr. Abernathy) able to re-calculate the value of every dollar as it leaves our hands to make a P&I payment on each loan as it compares to the value of the dollar the day the loan was closed. The buying power of the dollar declines at a compound rate, so inflation-adjusted dollars compared to the value of the dollar at the time of the loan means the borrower repays $82,583.83 in actual dollar value over 15 years and 81,586.71 over 30 years. How?
With a 15-year loan, Principal and Interest payments are $653.07, while the 30-year is $437.98. That $215.09 increased payment leaving the investor’s hands while the dollar is at a higher value results in higher inflation-adjusted repayment. The lower payment submitted over a longer period allows the borrower to repay with less in actual dollar value because of the increased time inflation has had to erode the money used for repayment. Unsure about the inflation estimate? Look for more explanation in future articles.
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