Reducing the length, or term, of your mortgage is a compelling reason to refinance. Shortening the term of your mortgage can potentially save you a significant amount of money over the life of your loan. Reducing the length of your mortgage from 30 to 15, 20 or even 25 years means you are not paying interest for those years which usually saves you thousands of dollars in the long run. Shorter length loans also have lower mortgage rates which further reduces your interest expense. So in general, reducing the length of your mortgage is one of the best reasons to refinance.
If refinancing to shorten your mortgage makes so much financial sense, then why do more people not do it? The answer is because shorter length mortgages usually have higher monthly payments which not all borrowers can afford. Although shorter mortgages have lower interest rates than loans with longer terms, reducing the length of your loan usually does not result in a significant reduction in your monthly payment because your principal balance is paid back over a shorter period of time. For example if you only have 15 years instead of 30 years to repay your mortgage, your monthly payment needs to be higher to pay back the loan. So if you decide to refinance into a shorter term loan, you need to make sure that a higher payment fits within your monthly budget.
Refinancing to reduce your mortgage term may not lower your payment but can save you thousands of dollars in interest
Even though your monthly payment may be higher, reducing your loan term can lower your mortgage rate and significantly reduce the number of monthly payments you make over the life of the loan, which will likely save you tens of thousands of dollars in interest expense. If you can reduce your loan term and lower your mortgage rate by refinancing then that is doubly beneficial.
The table below shows refinance loan terms for lenders near you. We recommend that you contact multiple lenders to understand how different loan lengths impact your mortgage rate and monthly payment. Comparing refinance proposals enables you to find the lender and loan that are right for you.
The example below illustrates the benefits of shortening your mortgage when you refinance. In this case, the borrower is five years into a thirty year fixed rate mortgage and reduces the term of the loan from 30 to 25 years. By refinancing, the borrower lowers his or her interest rate by .500%, less than the .750% reduction in rate typically required to justify refinancing a mortgage. Although the mortgage rate reduction is less than you would usually want, cutting the length of the loan provides a significant financial benefit to the borrower.
The refinance has a lower mortgage amount than the original loan, reflecting the pay down of principal in the first five years of the loan. In order to properly compare the original loan to the refinanced mortgage, we add the interest expense incurred during the first five years of the original loan to the interest expense incurred during the 25 year term of the new mortgage. The combined total interest represents the true cost of borrowing the original $380,000 loan amount. We also assume that the borrower pays closing costs but does not pay any discount points to further lower the mortgage rate.
The example demonstrates that by refinancing the borrower is able to save almost $30,000 in total interest expense over the life of the mortgage, even when you add in the interest expense for the first five years of the original loan. The borrower is also able to reduce his or her monthly mortgage payment by almost $100 despite having a shorter loan term which enables the borrower to recover the cost of refinancing in less than 20 months.
The key to the example below is that the mortgage balance did not change when the borrower refinanced. This enables the borrower to maintain an affordable monthly payment despite reducing the length of the mortgage. If the borrower had refinanced with the original $380,000 loan amount, the monthly payment would have increased and the borrower would have save less money on a monthly basis and in total interest expense. The example demonstrates the financial benefits of refinancing to shorten the length of your mortgage but also shows how your loan amount and interest rate affect the decision.
Refinance Your Mortgage to Lower Your Interest Rate
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"Adjusting the length of your mortgage." A Consumer's Guide to Mortgage Refinancings. The Federal Reserve Board, August 27 2008. Web.About the author