Whether an improvement in your home value, an improvement in your income, or an improvement in your credit profile is the trigger, when you're ready to refinance your home loan don't forget to look at your options for shortening your loan term. Refinancing from one 30-year fixed-rate loan into another is popular, but 34 percent of borrowers who refinanced during the first quarter of 2015 opted to refinance with a shorter loan term, according to Freddie Mac.
Loan terms and your financial plan
Refinancing your mortgage should be considered in the context of your short-term and long-term financial plans. When interest rates are low many borrowers decide it's time to refinance, but before you take that step you should think about how long you plan to stay in your home. If you expect to move within a year or two, then you should consider whether the cost of refinancing makes sense.
Consider your goals for refinancing: Are you hoping to lower your monthly payments? Or to reduce the amount of interest you pay over the life of the loan? Do you want to pay off your loan in full faster? Or do you plan a cash-out refinance so you can use your home equity to consolidate debt or make a home improvement?
Once you clearly understand your priorities you can make the best decision about whether a 30, 20, 15, or 10-year loan matches your needs.
Compare loan terms
Keep in mind that while your interest rate will be lower with a shorter term loan, your monthly payments could be higher since you must repay the loan faster. Mortgage rates change daily and depend on a variety of factors such as your credit score, your home equity, and the type of home you own such as a condo or a single family home. Here are some examples of payments for principal and interest on a $200,000 loan at different rates and terms:
30 years / 4.0% / $955
20 years / 3.8% / $1191
15 years / 3.2% / $1400
10 years / 3.1% / $1940
In addition to comparing loan terms, compare the new monthly payments to your current mortgage payments to evaluate your comfort level with the new amount. Compare the interest you'll pay over the life of the loan, too. For example, on a $200,000 loan you'll pay varied amounts of interest overall depending on the loan term:
30 years / 4.0% / $143,739
20 years / 3.8% / $85,837
15 years / 3.2% / $52,087
10 years / 3.1% / $32,855
Advantages to reducing your loan term
When you look at the chart above it's clear that a major advantage of shortening your loan term by 10 years or more can save you a significant sum in interest payments over the life of your loan. For instance, in the example above, you can save $57,902 in interest payments just by shaving off ten years when refinancing from a 30-year home loan to 20-year home loan.
Whether you want to build equity faster so you can sell your home for a bigger profit or to own your home debt-free before you retire, a shorter mortgage can help you attain your goal. Another reason some borrowers choose a shorter loan term is that they have already been making loan payments for several years and prefer not to restart the clock to a new 30-year term. Other borrowers want to tailor their loan payoff date to a child starting college or to their planned retirement.
The biggest disadvantage to a shorter loan term is that the payments can sometimes be significantly higher because of the reduced payoff timeframe. Of course, you need to compare the monthly payments your lender quotes you to your current payment. If you are lowering your interest rate significantly from your current payment or have paid down your mortgage balance and are therefore borrowing far less than you did originally, the payments on a shorter loan may be reasonable enough to fit into your budget.
If, however, your cash flow is tight, you have high interest debt to repay, lack emergency savings, or are behind in your contributions to retirement savings, you may be better off keeping your mortgage payments as low as possible with a refinance into a 30-year fixed-rate loan. After all, you can always make extra payments to reduce your mortgage balance in the future or even refinance again when you are better able to commit to higher mortgage payments.
Consulting with a lender is the best way to review your options and to weigh the pros and cons of various refinance loan terms in the context of your personal financial situation.