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Melissa and Jeff Joy got a pleasant surprise in January when their Dexter, Mich., home was appraised for a refinance: Its value had grown to $235,000 from $225,000 when they purchased it in 2010. That's no small thing in a state where home values are down 25%, on average, from 2007.
Then they got more good news: By adding $300 to their monthly mortgage payment, they could pay off the loan twice as fast, in 15 years instead of 30. They jumped at the chance to get rid of house payments in 2027, just when they'll need to start paying their son's college tuition. (Bing: Just how low are mortgage rates right now?)
When the Joys bought their home, their 5.25% interest rate seemed an excellent deal for a 30-year, fixed-rate loan. They knew they'd end up paying $144,000 in interest if they kept the home 30 years. But that's how mortgages work: The longer your loan term, the lower your monthly payments — but the more you pay in total interest.
Unheard-of low interest rates make this a remarkable moment for homeowners to shorten their mortgage terms, at least if they can qualify for a refinance and can afford a larger payment.
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Here are benefits and drawbacks to refinancing your mortgage to a shorter term.
Benefits
- Own your home outright faster. You'll be free of mortgage payments sooner, too. You still must pay taxes and insurance, though.
- Save on interest. The savings are potentially massive. Melissa Joy, a certified financial planner and co-owner of The Center for Financial Planning in Southfield, Mich., says she and her husband will save a whopping $128,190 in interest if they keep the new mortgage with its 3.375% interest rate for the entire 15 years.
- Equity builds faster. "It was noticeable right off the bat" says Melissa Joy, who sees equity piling up quicker on her monthly mortgage statements. Even if the Joys sell their home before the new mortgage is paid, they'll pocket more cash from the sale than they would have with the old mortgage.
For example, if the Joys had borrowed $200,000 over 30 years at 5.25% and sold their home in the 10th year of the loan, they would have accumulated $38,424 in equity from their payments. But by borrowing the same amount over 15 years at their new rate of 3.375%, they'll have roughly $129,000 in equity after 10 years.
- On our blog, 'Listed': 10% of mortgage mods reduced principal
Drawbacks
- You may not qualify. You'll need a strong mortgage application to satisfy lenders, and your home's appraisal must be high enough to support your loan request. That could be a problem if you have low or negative equity.
- Your payment may grow. Depending on the fees, the size and term of your loan, and the difference between your old and new interest rates, your new monthly payment is likely to be higher, maybe much higher. Or it could remain the same. The Joys' payment grew from $900 a month to $1,250.
- It's expensive. Fees of $5,000 or more could wipe out any benefit to refinancing. These charges may include an appraisal fee, inspection fee, private mortgage insurance, prepaid interest, application fee, loan origination fee, homeowners insurance, and points and fees imposed by the Federal Housing Administration or other government lending programs. The Federal Reserve's Consumer Guide to Mortgage Settlement Costs explains mortgage fees and estimates costs.
- The paperwork is a headache. Lenders may demand a lot of documents, from tax statements to old divorce papers. It can seem invasive.
- It takes months. Lenders are so busy now, and their lending requirements are so strict, that it can take months to get a loan approved. TD Bank, for example, averages 51 days to process a refinance from the time the application is submitted, says Michael Copley, executive vice president for retail lending at TD Bank. That's relatively quick. Some banks can take as long as 120 days. When choosing a lender, ask several about their turnaround times, Copley says.
