When does refinancing into a 15-year mortgage make sense?

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With the pandemic still prevalent and interest rates near all-time lows, now is a great time to think about a refinance. It may also be an opportune time to consider shortening your mortgage’s term in the process.Many homeowners choose to refinance from a 30-year fixed-rate mortgage to a fresh 30-year equivalent. While this can lower your monthly payment, it can add extra years to the total amount of time you’ll be financing your home. That means you’ll pay more in total interest over the combined terms of your original loan and your refinanced loan than you might expect.

15-year loan can help you save big on interest

Instead, it can be smart to pursue a refi with a shorter term. Refinancing from a 30-year, fixed-rate mortgage into a 15-year fixed loan can result in paying down your loan sooner and saving lots of dollars otherwise spent on interest. You’ll own your home outright and be free of mortgage debt much sooner than normal. Plus, mortgages with shorter terms often charge lower interest rates. Consequently, more of your monthly payments will be applied to the loan’s principal balance.

But a 15-year mortgage isn’t for everyone. Be aware that your monthly payment will likely rise because you’re compressing the repayment schedule over a shorter period. As a result, you’ll have less cushion in your monthly budget, particularly if you’re on a fixed income. That extra money you’ll be spending could earn a greater rate of return invested elsewhere. You’ll also have less ability to deduct mortgage interest paid on your taxes.

Yet if you have sufficient cash flow, this strategy can be advantageous, despite the higher monthly payment. Good candidates include homeowners who have lived in their home for several years and have a monthly budget and income that will enable the higher payment while also allowing wiggle room for other expenses, including repairs, maintenance and emergencies. Having extra money set aside for the unexpected is particularly important during the current economic downturn.

Before refinancing into a 15-year mortgage, shop around carefully and compare current mortgage refinance rates from different lenders.

Advantages of refinancing into a 15-year mortgage

Rajeh Saadeh, a real estate attorney, professor and investor in Somerville, New Jersey, says the benefits of refinancing to a 15-year loan are plentiful.

“Lenders often charge a lower interest rate for a 15-year mortgage than a 30-year mortgage. In addition to lowering your interest rate, you will create a more aggressive paydown schedule, which can save you thousands in interest in the long run,” he says. “Also, you’ll build equity more quickly, which you’ll be able to tap via a future home equity loan, home equity line of credit or cash-out refinance if you need extra money.”

Paul Buege, president/COO of Pewaukee, Wisconsin-based Inlanta Mortgage, notes that your monthly payment may not necessarily increase when moving from a 30-year to a 15-year mortgage loan.

“You may actually be able to reduce your monthly payment, depending on the size of your current mortgage and how much lower the new rate is compared to your current mortgage rate,” says Buege.

Drawbacks of refinancing into a 15-year mortgage

Having all your money tied up in your home can be risky. Many financial experts recommend having at least three to six months of emergency savings set aside in case you lose your job or cannot work for extended periods.

“You may not want to refinance if it will negatively impact your monthly cash flow. That’s especially true in the uncertain financial climate we’re currently in. You have to make sure you can continue to make payments or you could risk losing your house,” cautions William Stack, a financial advisor with Stack Financial Services LLC in Salem, Missouri.

Instead of refinancing a mortgage, you could contribute more money toward a 401(k) plan or an IRA account or beef up your emergency savings fund. The latter approach helps you avoid revolving credit card balances from month to month and incurring more debt at a higher interest rate.

“I believe that if you’re not maxing out any available employer match to your retirement plan, it’s a mistake to accelerate your mortgage payments by shifting to a 15-year mortgage,” says Allison Bishop, CPA, a financial coach in Portland, Maine. “You’re giving up a 100-percent return on your investment in favor of something more like a 3 to 4 percent return. It’s also smarter to put that extra money toward paying down higher-interest credit card debt if you have it.”

“Before you saddle yourself to the higher payments of a shorter-term mortgage, make sure you’re maximizing your tax-advantaged retirement savings options, your Health Savings Account and your 529 college savings accounts,” Greg McBride, CFA, Bankrate’s chief financial analyst, says. “Paying down a low-rate, potentially tax-deductible debt is a comparatively low financial priority.”

What’s the difference in payments for a 15-year versus a 30-year mortgage?

The minimum monthly payment on a mortgage is the amount required to be paid in full each month. As the minimum payment for a 30-year mortgage will be lower than that of a 15-year mortgage, this allows more flexibility within your monthly budget. That can come in handy if your income changes, you lose a job or you have financial emergencies to cover.

Before converting to a 15-year mortgage, carefully consider the impact on your finances. Evaluate your ability to pay monthly expenses and how the higher payment will affect your capacity to pay down debts and invest, versus staying pat with the remaining term on your existing 30-year mortgage.

If your goal is merely to pay down your mortgage faster, you can accomplish this by simply making periodic extra payments on your existing mortgage loan. If you make enough extra payments over your loan term, you can easily shave time off your loan — even 15 years if you prepay aggressively.

The catch with this strategy is that you’ll probably pay a higher interest rate on your current 30-year mortgage compared with a new 15-year loan. You’ll also have the hassle of managing, specifying and sending in extra payments that will need to be applied to your loan principal.

Let’s examine how a lower interest rate and shorter loan term affect the principal amount of a mortgage. In the following scenario, a homeowner with a 30-year, $200,000 mortgage can pay it off in 15 years by adding $524 to each monthly payment.

Adding payments to cut loan term in half
Interest rate Monthly principal and interest Total interest, life of the loan
30-year loan for $200,000, paid off in 30 years 4.00% $955 $143,739
30-year loan for $200,000, paid off in 15 years 4.00% $1,479 $66,288
15-year loan for $200,000, paid off in 15 years 3.5% $1,430 $57,358

Making accelerated payments provides flexibility. If you lose your job or have an emergency expense to cover, you can always skip one or more months of extra payments. A 15-year mortgage with a higher minimum payment, however, doesn’t give you that latitude.

To calculate the effect of making extra payments (each month, annually or one time), use Bankrate’s mortgage amortization calculator. Input the loan amount, term and interest rate, then click the “show amortization schedule” button, which reveals a section that lets you calculate the effect of extra payments.

Good candidates to refinance into a 15-year mortgage

Glenn Brunker, mortgage executive at Charlotte, North Carolina-headquartered Ally Home, says worthy prospects for shifting to a 15-year loan should meet specific criteria.

“The best candidate is a homeowner who determines that, after reviewing their overall finances, they can comfortably afford the higher monthly payments associated with a 15-year loan,” explains Brunker.

Ask Shea Adair, a Raleigh, North Carolina-based real estate agent and investor and he’ll suggest staying put for at least seven years after refinancing so that you can recoup your closing costs.

“I would also only recommend refinancing if you can lower your interest rate by at least 1 percent [100 basis points],” Adair says.

Robert Taylor, owner of The Real Estate Solutions Guy in Sacramento, a real estate investment company, says homeowners who have less than 18 years remaining on their 30-year mortgage are probably better off making extra payments toward principal over the next few years if they want to pay off their loan sooner.

“But if your current home loan has 18 or more years of payments left, or has an interest rate of 4 percent or higher, it might be worth refinancing into a shorter 15-year loan,” says Taylor.

Questions to ask before you refinance into a 15-year mortgage

  1. Can you afford the higher monthly payment?
  2. Is the money you ultimately save worth the higher payment every month, keeping in mind other goals you may have for the money?
  3. Will refinancing and paying more each month deplete your savings and emergency funds?
  4. Instead of making higher monthly payments, could you invest the extra money and earn a higher rate of return than the mortgage interest rate you’ll pay?
  5. Do you have other outstanding higher-interest debt (including credit card debt) that you should pay down first?
  6. Do you plan to remain in your home for several years after refinancing so that you can at least recoup what you paid in refinance closing costs?
  7. How many years remain on your current home loan? If it’s less than 18 years, is refinancing to a new 15-year loan worth it?
  8. How secure is your job? What would happen if you became unemployed or earned less in the future?
  9. Is it smarter and easier to simply make accelerated payments on your current mortgage?
  10. How much longer will you be eligible to deduct your mortgage interest paid if you refinance to a 15-year loan?

Featured image by StockImageFactory.com of Shutterstock.

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