Should You Refinance to a Shorter Term?

Should You Refinance to a Shorter Term?

There really is more than one reason to refinance an existing mortgage. Homeowners with a mortgage most often start to consider refinancing when interest rates have taken a dip. After all, a lower interest rate means lower monthly payments which saves borrowers money each month. There really is no direct correlation regarding how much lower rates must be before refinancing makes sense but rather how much money will be saved each month compared to how much the closing costs will be needed to obtain the loan. When thinking about refinancing, borrowers divide their costs by the monthly savings which will tell the borrowers how many months it will take before closing costs are recovered with the lower payment. But it’s also important to consider how long the existing mortgage has been in place.

How it Works

For example, someone has a 30 year fixed rate loan and the original rate was 4.25% and rates today are 3.75%, or one-half percent lower. The outstanding balance is $300,000. If that person is five years into the 30-year mortgage with 25 years remaining and then replaces the existing 30-year note with another 30-year note, the loan term has essentially been extended to 35 years and all the interest previously paid is an expense down the drain. But it might make sense when someone has a 30-year loan five years into it and rates are lower by taking out a 25-year term. Then, the math begins to work.

A shorter loan term will mean higher payments but the savings aren’t in the monthly payment but in the amount of interest paid to the lender over the life of the loan. Very early in the mortgage period, most of the monthly payment goes toward interest owed to the lender and much less to the outstanding loan balance. However, even the very little that goes to the principal balance still reduces the amount owed, but extending the loan term by another five years erases those gains. The additional interest due to the extended term will offset much or all of the benefits of lowering the principal balance.

Benefits of Refinancing

Borrowers can benefit from a refinance by getting a lower rate but they may also benefit by refinancing a first and second into one mortgage. A second loan will have a slightly higher rate than the first, so consolidating the two can also provide some advantages. When refinancing, pulling cash out during the transaction is also an option. Maybe switching from an adjustable-rate mortgage or a hybrid to a fixed makes good sense. Balloon payment coming due? It’s time to refinance.

The Takeaway

When refinancing makes good financial sense, don’t automatically replace the existing loan term with the same loan term. You’ve just added more interest you’ll pay over time. Instead, consider refinancing an existing loan term with the approximate term of the remaining note. If you’re 10 years into a 30-year loan, then take a look at a 10, 15 or 20 year term.