Refinancing to a 15-year mortgage saves big money
If you're one of the millions who have decided to refinance to take advantage of record-low mortgage rates, you would be remiss if you didn't also consider refinancing to a shorter-term loan.
Refinancing your 30-year mortgage into a 15-year loan might mean a higher monthly payment, but it will allow you to save thousands on interest and pay off your mortgage much sooner. Not only does the shorter term mean fewer interest payments, 15-year loans have significantly lower interest rates than their conforming counterparts.
"Borrowers could obtain even lower rates by choosing a 15-year fixed-rate mortgage, which averaged below 2.93 percent in 2012," says Leonard Kiefer, deputy chief economist at mortgage giant Freddie Mac in McLean, Va. "This was the lowest annual average for the 15-year fixed-rate mortgage since we began keeping track of the product in 1991."
"HSH.com has tracked 15-year fixed-rate mortgages since early 1986," says Keith Gumbinger, vice president of HSH.com. "These are not only record lows, but are less than half the interest rate available as recently as 2008, and, remarkably, more than eight percentage points below those 1986 rates. It would be hard to imagine a better time to take one of these short-term loans."
Those rock-bottom mortgage rates have made shorter-term loans positively trendy. A recent Freddie Mac report found that 27 percent of borrowers who refinanced in the fourth quarter of 2012 shortened the term of their loan, while 69 percent kept the same term and only 4 percent lengthened the term.
To understand how a shorter-term loan saves you money over the long term, compare a 30-year, $200,000 loan at 3.5 percent, to a 15-year, $200,000 loan at 2.9 percent. The monthly payment on the 30-year term was $898 and with a total interest expense of $123,312. The 15-year loan has a monthly payment of $1,371 and a total interest expense of $46,881. The monthly payment is $473 higher for the 15-year term, but the interest saved amounts to $76,431.
While borrowers traditionally don’t select 15-year loans for purchases due to steep price increases, refinancing older mortgages to shorter terms tends to have smaller increases, or sometimes no change in the monthly payments at all, adding to the incentive, says Gumbinger.
So, what are the pros and cons of a shorter-term mortgage?
In addition to the lower interest expense, the other major upside is the opportunity to build equity faster and own your home outright sooner, a goal that might be especially attractive if you're nearing retirement.
"There's a big incentive for a large portion of younger Baby Boomers to take advantage of these record low rates by transitioning from a 30-year fixed to a 15-year fixed-rate mortgage when they refinance because it provides them an opportunity to own their home free-and-clear based on their retirement planning," Kiefer says.
The downside is the higher payment, though that might be less of a leap than you'd imagine if your current loan has a high interest rate or you've paid down a chunk of your initial loan amount, says Justin Lopatin, vice president of mortgage lending at PERL Mortgage, a mortgage company in Chicago.
"When you refinance, you're borrowing the amount you currently owe, so you are restarting at a lower amount," Lopatin says. "For some people, there may not be a huge swing in payments because they've paid down so much of that balance."
Prepaying provides more flexibility
A compromise is to get a 30-year loan, then commit yourself to making higher payments or extra payments to reduce your principal more quickly. This strategy sacrifices the lower rate, but still builds equity faster.
"The conversation I'm having with people more often is 'Go ahead and get the 30 and you can control how you pay it off as if it was a 15-year mortgage. That's what I actually recommend," says Gary Parkes, vice president of mortgage lending at Guaranteed Rate, a mortgage company in Atlanta, Ga.
However, taking a 30-year mortgage instead of a 15-year does mean you don't get the lower interest rate commonly offered on the shorter-term product. You will preserve flexibility, but at a cost, says Gumbinger.
"You can actually prepay your mortgage into any term you like by using HSH.com's Its My Term Prepayment Calculator.”
Flexibility is important in case you later become cash-strapped, perhaps due to a job loss or reduced income and can no longer afford the higher monthly payment.
The big picture
You should have a healthy emergency savings fund before you devote extra money to paying off your mortgage, Parkes adds. One reason why that's smart is that home equity credit lines of credit aren't as readily available as they once were.
"I tell people to look at their whole situation, not just 'I want to get the mortgage paid off.' Look at all the factors," says Parkes.
Lopatin also emphasizes the importance of a big-picture approach. If you're planning to move or increase your household expenses within a few years or if you have another use for the money, a shorter term might not be the right choice.
"Does it make sense to spend more on your mortgage or does it make sense to leverage your mortgage, your (tax) write-offs and your equity and redirect that extra money into some type of investment?" he says. "For most people, a hundred dollars up or down can be significant."
The only way to know if you can afford to refinance to a 15-year mortgage is to run the numbers through HSH.com's mortgage calculator to find out how much higher your payment would be.
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Marcie Geffner is an award-winning freelance reporter, writer, editor and blogger whose work has been published by MSNBC, CNBC, Yahoo! Finance, Fox Business, Bankrate.com, AOL Real Estate, ThirdAge.com, Fidelity.com, Inman News and dozens of major U.S. newspapers. She holds a bachelor's degree in English from UCLA and MBA from Pepperdine University. You can follow Marcie on Twitter: @marciegeff.