When you refinance, you may be tempted to move from a traditional 30-year mortgage to a 15-year mortgage that allows you to build equity faster and pay less interest.
Before you take that step, figure out whether a larger monthly payment fits in your budget or whether you should simply pay more toward your current mortgage. Also, consider whether you’ll be approved for a new mortgage as the coronavirus downturn has led to stricter lending standards.
Here’s what you need to know to help you decide whether to refinance to a 15-year mortgage.
What Is the Difference Between a 30-Year and a 15-Year Mortgage?
The main difference is that a 15-year mortgage is half the length, meaning you’ll pay less interest over the life of the loan compared with a 30-year mortgage. But you’ll also make bigger payments, as you’ll pay off your mortgage in 180 installments instead of 360.
Despite interest savings, mortgages paid off over 30 years are the most popular type by far, says Mark O’Dell, manager of residential loans at Chicago’s Alliant Credit Union.
Some banks offer 15-year mortgage terms as well as lesser-known 10-year and 20-year mortgages.
Is Refinancing Worthwhile?
Refinancing is worth it if you can save enough money on your monthly payment to cover the cost to obtain your new loan.
Closing costs range from about 2% to 3% of the loan amount. That means you would pay between $6,000 and $9,000 on a $300,000 mortgage.
Let’s say you spent $6,000 to refinance. You would need to save $200 on your monthly payment over two and half years to recover the cost.
“The goal when people refinance is to lower the interest rate and lower the monthly payment” and then use the money toward other aims, such as savings, says Ron Haynie, senior vice president of mortgage finance policy, Independent Community Bankers of America.
Is Refinancing Into a 15-Year Mortgage a Good Idea?
Here are a few reasons that you might want to switch to a 15-year mortgage:
To save on interest. The rate for a 15-year mortgage could be about a half a percentage point less than a 30-year loan, saving you thousands throughout the life of the loan.
How much you save will depend on how many years are left on your loan, taxes and other expenses.
One example: If you traded a $300,000 mortgage at 3.6% over 30 years for a 15-year loan in the same amount at 3%, you could save $120,000 in interest.
To pay off the loan faster. If you have at least 20 years left on your mortgage and can get a good interest rate, a 15-year loan could help you pay off your home faster.
Look for a rate on a 15-year mortgage that is 1 percentage point lower than on your 30-year loan, Haynie says. Your monthly payment might be the same, depending on how much you still owe on the mortgage.
But, he adds: “It will pay your loan off faster and build equity faster.”
If your monthly payment is higher, though, make sure you can handle the drop in cash flow.
To prepare for higher expenses or lower income. Paying off your mortgage before retirement or major life events can help you reach your financial goals.
But be careful if you’re trying to retire soon or make a major purchase that will increase your monthly expenses. “You don’t want to get into a situation where you strap yourself to a significantly higher payment,” Haynie says.
To build equity quicker. Even if the payments are higher than on your 30-year loan, you are setting a more aggressive deadline to purchase your house, which could pay off in the long run.
“The decision between a 15-year and a 30-year is very specific to an individual’s situation, but if your goal is to create equity in your home more quickly, a 15-year is the better choice,” O’Dell says.
When Is the Best Time to Refinance to a 15-Year Loan?
The amount of time and money left on your mortgage is a major consideration when you decide whether to move from a 30-year to a 15-year mortgage.
If you have 25 years left on your mortgage, it might be too soon to jump into a 15-year loan unless you’ve paid down a chunk of your debt and can get a much lower interest rate. The higher the loan principal, the more likely your monthly payments will rise significantly.
Also, you may face a prepayment penalty if you pay off your loan at this point because the loan is relatively new.
If your monthly payments on a 15-year mortgage would be much higher than they are now, Haynie says to ask yourself: “Does that make sense, given what your life plan is (and) what’s in front of you?”
Your payments could put you in a difficult financial situation by restricting your ability to pay for ongoing expenses and pay off debt.
If you’re halfway through a 30-year mortgage, the timing might be ideal for refinancing to a 15-year loan. That’s because you have basically the same amount of time left on the loan and can take advantage of a lower principal balance, Haynie says.
If you have about 10 years left on a 30-year mortgage, Haynie says, “I wouldn’t refinance it.” You could just add a couple hundred dollars to your monthly payment and be better off than you would refinancing and owing thousands of dollars in fees.
“At that point in the life cycle of a loan, you’re just paying principal, not paying a whole lot of interest,” Haynie says.
If you know you’re going to sell your house in a few years, you could refinance into an adjustable-rate mortgage, or ARM. This will allow you to get lower payments for a period of time before you sell.
You’ll need to make sure you stay in the house long enough to make up the refinancing fees.
Keep in mind that the rates on ARMs might not provide an advantage over fixed-rate loans because of today’s low rates, Haynie says.
What Are Alternatives to 15-Year Mortgages?
You can still reach your goal of paying off your home loan early without turning to a 15-year mortgage. Here are a few ways how:
Take out a 20-year mortgage. You don’t hear a lot about this option, but it can offer an eighth or a quarter of a percentage point drop in interest from a 30-year mortgage, Haynie says.
“It’s an alternative to taking out a 30-year loan and, in essence, starting over again,” he says.
Adds O’Dell: But the 20-year mortgage is much less attractive to consumers because interest rates more clearly mirror the 30-year rate product than a 15-year loan.
Pay extra on your 30-year mortgage. If you keep your 30-year mortgage but want to pay it down faster, you could put a little more toward the principal each month to reduce the number of payments you’ll have to make. Another option is to set up automated biweekly payments, which result in an extra payment each year and could help you save on interest and knock a few years from your mortgage.
The latter approach requires more discipline, Hayne says.
If you’re still uncertain whether to refinance, O’Dell suggests asking yourself whether you can comfortably afford the higher 15-year loan payment.
“If that is an issue, simply making one to two extra payments per year on a 30-year mortgage can help you pay your loan off more quickly while still keeping your lower 30-year mortgage payment,” he says.