Is refinancing with a 15-year loan a better choice than a 30-year mortgage? It's a question which could lead to huge interest savings.
Long-term financing has been a grand tradition since such loans were popularized by the FHA in the 1930s. Today borrowers can readily get financing and refinancing not only with a 30-year term, but also with 15-year loans.
In comparing 15- and 30-year mortgages there are several benchmarks to consider. To make the examples clear, let's imagine that 30-year, fixed-rate financing is available at 4.32 percent and that the amount being borrowed is $150,000.
Because 15-year loans are shorter, and because they amortize more quickly, 15-year financing represents less risk to lenders than mortgages with longer terms. The result is that a 15-year loans are typically available with lower mortgage rates.
How much lower? The answer varies but as one example imagine that 30-year loans are available at 4.32 percent while 15-year mortgage rates are priced at 3.37 percent.
We usually associate lower interest rates with smaller monthly mortgage payments, but for 15-year and 30-year loans that equation does not hold up. In our example, the monthly costs for principal and interest look like this:
The 30-year loan at 4.32 percent has a monthly cost for principal and interest of $744 while the 15-year mortgage at 3.37 percent requires a monthly payment of $1,063.
The 30-year loan requires 360 monthly payments while the 15-year loan must be repaid in 180 months. With less time to repay the debt the cost-per-month is higher -- however, your payments are not twice as high, even though you'll repay the loan in half the time.
When looking at monthly costs, it's good to remember that a mortgage is a contract. FHA, VA and conventional loans held by Fannie Mae and Freddie Mac all allow borrowers to prepay their mortgages without penalty, so although you can freely pay more each month you can never pay less than the required monthly payment.
For many borrowers, the shorter term of the 15-year mortgage is attractive but the larger monthly payments are a hurdle. Another roadblock is more subtle: What if at some time in the future, the homeowner's income declines? In that case, the 30-year loan is easier to handle because the monthly cost is lower.
One way to get many of the benefits of a shorter term but with the lower monthly costs of a 30-year mortgage is to make monthly prepayments. For instance, if you add $100 a month to $744 then the $150,000 mortgage at 4.32 percent will be paid off six years earlier.
Refinancing for Savings
Fifteen-year mortgages plainly have lower interest rates when compared with their 30-year brethren. Combine lower rates with shorter terms and the potential savings can be impressive.
Our 30-year loan for $150,000 at 4.32 percent has a lifetime interest cost of $117,865 versus just $41,298 for the 15-year alternative at 3.37 percent. The concept of far-lower costs for loans with shorter-terms is accurate, however such lifetime savings are unlikely to be fully-realized because few loans are held for their entire term.
What is also true -- and what can be an important consideration -- is that the debt with shorter-term financing is paid off faster. As an example, after eight years the balance for our 30-year loan is $126,647 versus $79,426 for the 15-year mortgage.
That's more than $47,000 in additional equity with the 15-year mortgage, the by-product of the lower rate and higher monthly payments for our model loan.
Whether one gets to the promised financial land of less debt and lower costs by using a short-term loan or with prepayments, the idea is always the same: Less debt over time means lower costs and more financial freedom -- a very good reason to look at both 15-year financing and voluntary prepayments.