Mortgage interest rates have dropped significantly over the past few years and many homeowners and investors are taking advantage of them to save money on payments and interest. If you’re in the market to refinance for a lower rate, I encourage you to consider shortening your loan term as well. You won’t necessarily end up with a lower monthly payment (it might even be a little higher), but you’ll pay off your home off faster and save a ton of interest over the life of the loan.
To demonstrate the incredible wealth preserving power of a shorter loan term, let’s take a look at a loan scenario that’s based on the actual situation of one of my past clients. Let’s assume our hypothetical borrower currently has a 20-year fixed loan at 7.75% that he’s been paying on for 4 years and wants to refi for a lower rate and shorter loan term. The following are his refinance options, which assume the lender covers all 3rd party closing costs and the new escrow deposits will be rolled into the loan:
Notice that as the loan term decreases from 20 years to 10 years the interest rate decreases as well. Loans with faster payoffs carry less risk, so lenders are willing to offer lower rates for shorter term loans. For instance, a 15-year fixed loan often prices out 0.5% lower than a comparable 30-year fixed loan and a 10-year fixed loan often prices out another 0.125% to 0.25% lower than the 15-year fixed loan. The popular 30-year fixed loan generally carries the highest rate of all fixed loans because the lender shields you from interest rate risk for an entire 30 years. A lot can change in the world over 30 years, so the lender wants to be compensated for protecting you from long-term interest rate risk.
Another great benefit of a shorter-term loan, in addition to the lower rate, is that you’ll build equity much faster. Growing your home equity grows your net worth, so you can look at your equity like a savings account that grows as your property appreciates and your loan balance decreases.
Check out the chart below, which shows the principal and interest breakdown for our borrower’s current loan and the loan options he is exploring. Notice how much more of the payment goes to principal as you go from left to right in the chart. The first payment for the new 20-year option only contributes $318 toward equity while the 10-year option contributes $890!
The combination of the shorter term and rate discounts you get with a 20-, 15-, or 10-year loan over a 30-year loan results in a ton of interest saved over the life of the loan. Plus, you get your house paid off a lot faster too! To me, a dollar saved is a dollar earned; the interest you save on your mortgage is wealth that remains in your pocket instead of going to your mortgage lender.
Check out the chart below, which shows the total accrued interest over the life of the various loan options our borrower is exploring.
If our borrower opts for the 15-year loan, he’ll save over $45,ooo in interest versus continuing to pay on his existing 20-year fixed. If he opts for the 10-year, he’ll save over $67,000 versus his current loan. Sure, the payment for the 10-year option is nearly $200/month higher than his current payment, but unless he is super tight financially, there’s probably some other areas in his budget where he can trim back.
If you’re in the market to take advantage of today’s low rates and refinance an existing loan, consider taking out a shorter-term loan, such as a 15-year or 10-year fixed. Yes, the payment is higher than a 30-year fixed loan, but consider it an investment in your net worth. You’ll put tens (or even hundreds!) of thousands of dollars back into your pocket instead of sending it to you lender. Consider cutting out some unnecessary expenses to make up for the increased house payment. Believe me, your net worth will thank you!
Latest posts by Mark Fitzpatrick (see all)
- How to Finance a Home: The Basics of Qualifying for a Home Loan - March 20, 2012
- FHA Mortgage Insurance Premiums Set to Increase in April - March 12, 2012
- What is a Debt-to-Income Ratio (DTI) and How is it Calculated? - December 30, 2011