Is a shorter-term mortgage right for you?
You may pay off your home loan quicker, but you'll also pay more per month. Here's a look at the pros and cons of this practice.
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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.
- 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.
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- 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.
Making the call
Nearly 80% of all mortgages in the U.S. are refinances, according to Freddie Mac, the government-managed mortgage company. Most have fixed rates. In addition to 30-year loans — the most popular option for banks such as TD Bank — there are loans with terms of 10, 15, 20 or 25 years. Adjustable-rate mortgages can have terms of three, five, seven, 10 or 15 years. (Bing: Do you need to repair your credit?)
One of these shorter-term mortgages could be a good idea, but it's a personal decision based on a lot of factors. "It depends on the individual, their equity position, their savings, where they are on the retirement spectrum," says Michael S. Rosenbaum, a loan officer with W.J. Bradley Mortgage Capital in San Diego.
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As attractive as freedom from mortgage payments may sound, it's a mistake to stretch your finances too far, Joy says. The evidence is all around, in the stories of thousands who lost their home to foreclosure because they took on payments too big for their income.
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You may feel more financially secure sticking with the lower monthly payment and a 30-year term.
"It should be taken into context with everything else in your life, including your cash flow from month to month," Joy says. "You want to build in a margin of safety. You don't just want to consider the best-case scenario," she says. If you or your spouse lost your job, could you swing that higher monthly mortgage payment?
Here's a checklist that Joy uses for herself and clients. It can help you decide if refinancing into a higher payment is safe for you:
- Are you funding retirement savings, including contributing at least enough to trigger the maximum amount of any matching contributions from your employer?
- Have you saved three to six months' worth of living expenses in a separate account for emergencies?
- Would you have enough cash left over each month to keep paying down any other debts?
- If you are a parent, could you contribute to your children's college savings?
If you answer yes to every question, a shorter-term mortgage may be a great idea now, especially because ultralow interest rates may not be around forever, Joy says.
There's a safer, middle way to go if you really want to pay down your existing loan fast but are worried about locking in higher payments: Pay something extra each month. Or make one or two extra payments each year.
You can use a mortgage-payoff calculator to run your own numbers. If you want to pay off your mortgage in 20 years, you may just need to make one extra payment a year, Copley says.
When shorter terms work
No single solution works for everyone, Rosenbaum says.
One of his clients, a man in his late 30s, has lowered his interest rate by 1.75% by refinancing four times in less than four years. In his recent refinance, he chose a 30-year term after briefly considering a shorter mortgage. But, Rosenbaum says, this client is "all about the cash flow. The idea of throwing too much toward the principal doesn’t make sense right now. He isn't about paying it off 30 years from now. The home, great as it is … will be something they've sold off or converted to a rental property at that point."
The client's new 3.75% rate also includes his loan fees. That cost him about a quarter of a percentage point, or $30 to $40 more a month.
Another of Rosenbaum's clients refinanced out of a 30-year mortgage and into a 10-year fixed term at 3% — while lowering his monthly payments. Reducing the loan term and the monthly payment is "pretty rare," Rosenbaum says. But this homeowner had some advantages: He had been paying off the loan for 12 years, and his rate dropped from 6.5% to 3%. Also, years of payments had shrunk his mortgage balance enough so he could borrow considerably less money this time.
For him, a 10-year term "was a no-brainer," Rosenbaum says. Also, the man is in his 60s, and retiring with a paid-off home is important to him. He has plenty of cash, so lowering his monthly payment through a 30-year term doesn't matter as much as it might to someone else.
Rosenbaum tells of a third recent client who chose a five-year mortgage for his refinance. What's more, the man wanted an interest-only, adjustable-rate mortgage, a loan that many consider risky. The rate is reset periodically, and it can rise. Also, paying only interest never gets you any closer to owning your home outright.
Interest-only mortgages were sold aggressively to lower-income borrowers by some lenders during the bubble. That led to defaults when the escalating payments grew beyond what homeowners could afford.
Before that, however, short-term interest-only loans were marketed primarily to high-income homeowners as a sophisticated financial tactic. Because these loans' interest rates are cheap, at least initially, wealthy borrowers can use the savings to earn a better return on their money elsewhere — a rental property, business investment or annuity, for example, Rosenbaum says.
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The client, an attorney, has more than 50% equity in his $850,000 home and plenty of savings.
"In a conservative, responsible way, I have to admit it makes sense for him because the downside and the risk is not there for him," Rosenbaum says. If the rate rises too far, "He can pay it off tomorrow."
These tales illustrate the experts' point: Homeowners should tailor the products and terms they choose to their individual situations. It may be a complex decision. You can get free help from a Department of Housing and Urban Development housing counselor by calling 800-569-4287 or using this map to find a counseling agency near you.
The low-rate window for cutting your mortgage term is likely to stay open for a while. Rates should remain low through 2014 and maybe into the first half of 2015, Copley says.
Since January, when the Joys refinanced, rates kept dropping, to an average of less than 3% for 15-year fixed mortgages and less than 4% for 30-year, fixed-rate loans.
But there's no promise they'll drop further. If you try too hard to time the decision, you could miss your chance.
"Rates have come down a little bit from where we were at, but there's no regret about making the decision when we did," Joy says. "It's always going to be a moving target. You just need to get it generally right."
If you take a $160,000 loan at 3.5%, at 30 year payment would be $718. Making an additional $200 payment will "save" you $34,911 and you will pay off the loan in 243 months.
If you instead take that $200 and invest in the market and get an 8% return, you can pull out your investment at 243 months, adjust for a capital gains tax of 15%, and pay off the loan in full and pocket an additional $33,047. Don't think you can get an 8% return? If you get 5% you still pocket $1649.
Result, don't pay off your loan early at the current interest rates, you are just throwing money away.
If you're young, have a secure long term income, and can save additional funds, a 20 yr or even
15 year mortage is a definite yes. Now that interest rates are low. When (if) the economy turns
around the rates will go up, so lock in your interest rate. If you're 25, and have a 15 year loan,
your paid up by 40. You can re-fi for a well deserved vacation or some kind of treat.
Make sure you save for a rainy day or you could undo all your efforts. The bigger monthly payments should make you cautious about unnecessary frills. Also, over the years your income
will likely improve, but be ever mindfull of the possibility of losing the income you've counted on.
Over time, save enough to cover all of your bills for ONE FULL YEAR. More often than not you
will be unemployed for a year before you get re employed at the level you desire.
if you cannot afford the long run how the hell you going to afford the short? our financial realism
it not a sport, we are commin g out far far short, we have let our system ruin us by their doin us"
and untill we unite with our futures in sight we shall fall further into greeds bitei, people frown
thinkingme a clown, but my truths one day to make us soundt fropwn
I would suggest most people start by contacting their existing lender to see if they can offer a better rate. I had a loan through Wells Fargo, and they offered me a lower rate with no points/closing costs because I was a good customer. They did the same for my neighbor. If you are a good payer, they will want to keep you as a customer and will likely help you out.
Of course, if you are a dead-beat and missed a few payments, you are out of luck.