Feb 5, 2020
With mortgage rates falling and financial experts predicting an unstable future for the economy, lots of homeowners are rushing to refinance their mortgages to lock in low rates. One increasingly popular option is to refinance a conventional 30-year mortgage into a 15-year loan.
Borrowers may be wondering if this is a financially sound move to make for their own home loan.
We’ve researched this option and worked out the numbers so you can make a responsible, informed choice about your own mortgage.
When refinancing can be a good idea
The primary attraction to a shorter mortgage term is paying off your home loan sooner, typically at a lower interest rate. This can help you increase your home equity faster and can mean paying thousands of dollars less in interest over the life of the loan. Therefore, refinancing to a shorter-term loan makes the most sense when interest rates are falling.
It’s also a particularly good idea for homeowners who can easily afford to increase their existing monthly mortgage payments. In addition, homeowners whose home values have increased since they financed their original mortgage will be more likely to qualify for a 15-year loan, since they will have a lower loan-to-value ratio —how their home’s current value compares with their current loan balance.
How much money can I save?
There is no quick answer to this question, as there are several variables at play in each refinance. To provide a basic idea of what a shorter-term home loan can mean for your finances, let’s take a look at how the numbers would work out in a 15-year refinance on a conventional home loan.
As mentioned, a 15-year loan generally carries a lower interest rate than a 30-year loan. If national interest rates are falling when you refinance, and/or your credit has improved since you bought your home, your interest rate can be even lower. According to Bankrate’s most recent survey of the nation’s largest mortgage lenders, on Dec. 6, 2019, the benchmark 30-year fixed mortgage rate was 3.74 percent and the average 15-year fixed mortgage rate was 3.16 percent.
Let’s assume you refinance your fixed $300,000 mortgage with an interest rate of 4.5 percent to a 15-year loan at an interest rate of 3.5 percent.
If you kept your existing mortgage unchanged for 30 years, you’d be making 360 payments over the life of the loan at $1,520.06 a month, not including taxes, insurance and other fees.
Toward the beginning of the loan, an overwhelming majority of your monthly payment will go toward interest, with less than $400 going toward your principal. By the time you pay off your loan, this ratio will reverse itself and the majority of your payments will go toward the principal of the loan. Most importantly, over the life of your loan, you will have paid $247,220.13 in interest.
Now let’s explore what these payments would look like if you refinanced this loan to a 15-year fixed-rate loan at a 3.5 percent interest rate.
Over 15 years, you would make 180 payments of $2,144.65. Over the life of the loan, you’d be paying $86,036.57 in interest payments, bringing significant savings of $161,183.56. You’d also be chipping away at your principal at a far quicker pace, with $1,269.65 of your very first payment going toward the principal of the loan.
If these numbers are exciting you about getting your refinance process started, take a step back and slow down. First, these numbers may or may not translate directly to your own situation. In the above example, savings are calculated over 30 years, but you may be nearing the halfway point of your 30-year mortgage. A refinance can still be a good idea if it can get you a lower rate for the remainder of your loan, but your interest savings will be significantly less than those described above. Second, your interest rate may not be a full point lower after a refinance, as it is in our example. This, too, will afford you less savings.
There are other crucial factors to consider before jumping into a 15-year refinance. Read on for a review of some of the more important variables to think about when making this decision.
What will a refinance cost?
Refinancing your mortgage is not cost-free. Expect to pay a minimum of 2.5 percent of your new loan in closing costs and other fees.
Here are some of the possible fees you can expect during the refinance process:
- A fee for pulling your credit
- A fee for processing your paperwork
- Lawyer fees
- An inspection fee
- Discount points, each of which are equal to one percent of your home loan, which will give you a lower mortgage rate
- An appraisal fee
- A surveyor fee
- Title search fee
- Title insurance
Before you get started on the refinance process, it’s a good idea to tally up these expenses and see how much it would cost you to refinance.
You might be offered the option of refinance at no cost. This means your closing costs will be rolled into your new mortgage payments. This can make financial sense if it means saving money in the long term, but it’s a good idea to work out the numbers before you continue with the process.
Finally, your existing mortgage may have prepayment penalties, which can cut into the amount you’ll save by refinancing. Find out about these fees before you set the refinance process in motion.
When refinancing to a 15-year mortgage is not a good idea
If you’re convinced that a 15-year refinance is right for you, make sure to consider this crucial factor before going ahead with the refinance: Your monthly mortgage payments will increase significantly after a 15-year refinance. In the example above, the mortgage payments increased by $624.59 a month. Your own payments may see a similar change, and any increase will impact your finances.
If you’re financially responsible, you won’t consider this move unless you are confident you can afford to meet this increased mortgage payment. However, you may not realize that tying up your spare cash in your home’s equity can be a risky move. It can make more financial sense to first build an emergency fund with 3-6 months’ worth of living expenses, and to increase your retirement contributions. If you’re carrying any high-interest debt, you’ll want to pay that down, too, before moving ahead with a refinance.
Increasing your monthly mortgage payments can mean leaving you with a tighter monthly budget and very little breathing room. Make sure you are fully prepared to swallow these costs before you go ahead with a refinance.