Is it smart to refinance to a 20- or 15-year loan?
You’ve accomplished a major goal: Buying a home. Only the next major associated goal seems an awfully long way off—owning it outright. That means paying down what’s likely a 30-year mortgage loan. If 30 years sounds like an eternity, that’s because it seems like it to the average homeowner.
But you don’t have to feel like a prisoner to long-term home financing. Instead, consider refinancing your mortgage to a shorter-term, possibly a 15-year-loan. Doing so will not only pay off your mortgage more quickly; it will save potentially tens of thousands in interest, too.
“You can save a significant amount of money by refinancing to a shorter-term. “A 20-year or 15-year loan also charges a lower interest rate–often at least 0.25% to 0.50% less than a 30-year loan. And a shorter amortization period means each payment has less interest in it,” says Brian Koss, executive vice president of Mortgage Network in Danvers, Massachusetts.
Additionally, you can build equity in your property more quickly by opting for a shorter-term mortgage. That equity can act as a safety net to borrow against if times get tough, notes Chuck Biskobing, a closing attorney with Roswell, Georgia-based Cook & James.
“Also, for many people, the peace of mind associated with getting their mortgage paid off is worth it,” Biskobing says. “With a 15-year mortgage, the end is actually something you can see, whereas a 30-your mortgage seems like it will go on forever.”
Brett Warren, the Philadelphia-based director of residential mortgage lending for Hyperion Bank, illustrates how much money you can save by refinancing from a 30-year mortgage to a 15-year mortgage.
“Say you borrow $250,000 to buy a home. With a 30-year fixed-rate mortgage at 3% interest, you’ll pay $1,054 per month, not including taxes or insurance, or $380,000 over the life of the loan,” says Warren. “But if you opt for a 15-year fixed-rate loan, which probably carries a lower interest rate–2.5%–although your monthly payment will go up to $1,667 a month, you’ll pay $300,000 over the life of the loan. That’s a savings of $80,000. Plus, you will have paid off the loan in half the time.”
The strategy of picking a shorter-term mortgage makes sense for lots of folks.
“Many people want to get a home paid off before they retire. Also, for those with a stable income sufficient to support the higher mortgage payments, it may make sense to go ahead with a shorter-term mortgage,” says Biskobing. “And for people who want to be debt-free, this is a no-brainer. A 20- or 15-year mortgage leads to an enforced debt reduction plan, whereas most people with a 30-year mortgage pay down little of the original balance before they sell or refinance.”
However, it’s important to ask yourself crucial questions before making this major refi move, including:
-Can I afford the higher payments that come with a shorter-term mortgage?
-How stable is my income?
-How long do I plan to live in this property?
-Will I need cash for repairs or renovations that may be difficult to fund if I have higher mortgage payments?
-Can I use the extra money I will spend on mortgage payments more effectively elsewhere?
A smarter alternative to refinancing to a shorter-term could be making accelerated mortgage payments.
“You can always make additional payments to your principal balance when funds are available to you, which will have the effect of lowering your loan’s term automatically without having to go through the hassle and expense of refinancing,” Warren says.
Or, “you can request a mortgage modification with your lender to reduce the interest rate on your current loan without going through the whole refinance process,” recommends Claire Toth, vice president at Point View Wealth Management in Summit, New Jersey. “A modification likely won’t reduce your mortgage rate as much as a full refinance would, but the benefits can outweigh the avoided costs.”
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