Monday, May 14, 2018

Is a 15-Year Mortgage Right for You?

Is a 15-Year Mortgage Right for You?
While taking out a mortgage is both the norm and often the only realistic way to become a homeowner, it can also feel like a huge financial burden.

It’s often one of your biggest monthly bills, making it harder to find room in your budget for other financial goals. And it’s often your biggest debt — with a long payoff period to boot — which can make the goal of becoming debt-free feel remote.

Research shows that carrying debt is a huge drain on happiness and that paying it off is one of the most emotionally satisfying financial moves that you can make.

But that can often feel like an impossible task. Between student loans, auto loans, credit cards and mortgages, it might seem like becoming debt-free is more of a pipe dream than a realistic goal.

There are ways to relieve some of that burden though, and one route to consider is refinancing your mortgage. Specifically, a 15-year refinance can save you a lot of money and help you pay off your biggest debt a lot sooner than expected.

There’s a lot to consider before jumping into a 15-year refinance, and this post will walk you through the pros and cons, as well as what you need to do to prepare for the refinancing process.


What to consider before refinancing to a 15-year mortgage

Depending on your situation, refinancing to a 15-year mortgage could either improve your financial situation or make it harder to reach your other financial goals.

Here are some of the major factors to consider before making a decision.

1. Lower long-term costs

Jennifer Beeston, VP of Mortgage Lending at Guaranteed Rate Mortgage, points out that there are two factors leading to significant long-term savings from a 15-year mortgage compared with a 30-year mortgage.

The first is the fact that 15-year mortgages generally carry a lower interest rate than 30-year mortgages. Using LendingTree’s mortgage rate tool, a 30-year, $250,000 mortgage in Brooklyn, N.Y., would currently have a 4.25% interest rate for someone would excellent credit. That same mortgage with a 15-year term would only have a 3.75% interest rate.

The second factor is that you’re paying off the loan in half the time. Beeston explains that by paying interest for a shorter period of time, you end up paying a lot less interest overall.

“You are paying less for the house than if you did a 30-year fixed mortgage,” Beeston said. “A shorter period and lower interest rate equal less interest paid to the lender. This results in huge savings.”

Using the example above, someone taking out the 30-year mortgage would pay $192,745.80 in interest over the life of the loan, while someone taking out the 15-year mortgage would only pay $77,249.86 in interest.

That’s $115,495.94 in savings that could be put toward other goals, in addition to getting you out of your mortgage 15 years sooner.

Your specific savings will depend on the current balance and years remaining on your current mortgage, as well as your current interest rate and the rate you could get from refinancing. But in general, the long-term cost savings of a 15-year refinance can be significant.

2. Building equity

One of the other appeals of a 15-year refinance is the opportunity to build equity in your home faster than you would with your current mortgage.

Sticking with the example from above, and assuming a $50,000 down payment, you would have $59,369.29 in home equity two years into your 30-year mortgage. After those same two years with a 15-year mortgage, you would have accumulated $75,798.52 in equity.

That’s an extra $16,429.23 that could be yours if you sold the home, or that you could access through a home equity loan if the need arises.

3. Closing costs will eat into your overall savings

A 15-year refinance isn’t a free lunch. You’re getting essentially a new mortgage and that means paying closing cost fees all over again. You’ll likely have to pay 2% to 3% of the loan amount in upfront closing costs, which may be difficult to afford and can eat into the long-term savings from the refinance.

For this reason, the amount of time you plan to stay in your home can be a big factor in determining whether refinancing is a smart decision. If you plan on moving soon, there may not be enough time for the monthly savings to outweigh the upfront costs.

You can use a refinance calculator to help you run the numbers and figure out just how long you’d have to stay in your home for a 15-year refinance to be cost-effective. In general, the longer you plan on staying, the more likely it is that a refinance will save you money.

4. Increased monthly payments

One of the reasons that the cost savings are so significant with a 15-year mortgage is that your monthly payment is higher than with a 30-year mortgage. With more money going toward the mortgage each month, the loan is paid off quicker and you end up saving money.

But Tyler Landes, CFP®, a fee-only financial planner and the founder of Tandem Financial Guidance, cautions that while the savings are great, you need to consider whether you can actually handle that larger monthly payment.

“Even though it can save money in the long run,” Landes said, “you need to make sure that it’s something you can afford in your budget before locking into a higher monthly payment.”

Sticking with the example above, the monthly payment on the 15-year mortgage would be $1,818.06, as opposed to a $1,229.85 monthly payment on the 30-year mortgage. That’s an extra $588.21 per month, which may or may not be manageable depending on your other expenses.

5. How many years are left on your current mortgage

If you have less than 15 years left on your current mortgage, a 15-year refinance would effectively extend the length of your mortgage and could end up costing you money in the long run.

In this situation, you may be better off simply putting extra toward your current loan, assuming that you wouldn’t face any prepayment penalties. This would allow you to pay your mortgage off quicker without extending your loan term and facing the associated increase in interest costs.

Alternatively, Matthew Roder, VP of Mortgage Banking at BeMortgage, says that executing a 15-year refinance might be ideal when your current mortgage has 17 to 20 years left.

“Due to the lower rate of a 15-year fixed loan,” Roder explained, “the borrower may be able to refinance into the 15-year fixed, keep their monthly payment very close to what it is currently, but pay off their loan two to five years sooner.”

6. Other financial priorities

While paying your mortgage off early is a fantastic goal, and while it has a number of financial benefits, it’s important to consider how a 15-year refinance might impact your ability to reach your other financial goals before jumping in.

For example, are you currently saving enough for retirement? Do you have an emergency fund? What about life insurance or wills? Have you started saving for your child’s college education?

Landes says that focusing on those other goals first, and even focusing on other debts, may be the right move.

“Using surplus cash flow to pay off credit cards, auto loans, and student loans is usually a better use of funds to get started”, Landes said. “Having an emergency fund is essential, and if you have young children, you also must consider term life insurance to provide for them if something happens to you.”

There’s also the question of return on investment. While future returns are not guaranteed, stocks and bonds have generally produced better returns than what you receive from putting extra money toward your mortgage. And many retirement and college savings accounts — such as 401(k)s, IRAs and 529 plans — offer tax breaks that can yield even higher returns.

The bottom line is that the decision to refinance should not be made in a vacuum. You need to consider your entire financial situation and all of the opportunities available to you before you can determine whether a 15-year refinance is the right move.

Summary of the pros and cons of a 15-year refinance

As you try to figure out whether a 15-year refinance makes sense for you, here’s a quick summary of the major pros and cons:

How to refinance from a 30-year mortgage to a 15-year mortgage

If you do decide that a 15-year refinance is the way to go, there are a number of steps you’ll have to complete in order to get it in place. Here’s a summary of things you’ll need to consider.

Gather the right documentation

Lenders will require certain documentation before making a refinance offer, and it helps to have those documents prepared ahead of time.

Here are the documents you will likely have to provide:

- W-2 from at least the past year, and possibly the last two years

- Pay check stubs from the past 1-3 months

- Proof of additional income, if applicable

- Tax returns from the past 1-2 years

- Profit and loss statement for the past year, if self-employed

- Checking and savings account statements

- Investment account statements

- Statements for other debts, such as student loans, auto loans and credit cards

- Driver’s license

Your lender might request additional documentation as well, so be prepared to gather more if necessary. The more organized you are to start, however, the easier this process will be.

Evaluate your credit score

Your credit score is an important factor in determining your eligibility for refinancing, as well as the interest rate on your new loan.

Credit scores are generally evaluated in bands, with a score of 760-850 generally deemed to indicate excellent credit, and therefore qualify you for the lowest interest rates.

Lenders will also often require a minimum credit score in order to qualify for a refinance. According to Roder, a credit score of 680 or above should allow you to qualify for most conventional loans, and a score of 620-679 might require a larger down payment in order to reduce the lender’s risk. But there are options for borrowers with poor credit, too.

FHA loans are less strict, typically allowing you to borrow with a credit score of at least 500. You may even be able to qualify for a streamline refinance that ignores your credit report altogether.

You can use LendingTree’s Credit Score tool to estimate your credit score, though it’s worth noting that every lender may evaluate your score a little differently. You can also pull your entire credit report for free at annualcreditreport.com.

If your credit score isn’t where you’d like it to be, or if you’re a few points away from moving into a higher category, it could be worthwhile to work on improving your credit score before you apply for a 15-year refinance.

Calculate your debt-to-income ratio

Your debt-to-income ratio is calculated by adding up all of your monthly debt payments and dividing that total amount by your gross monthly income. It measures the percent of your income that is dedicated to debt payments, and it’s a key indicator that lenders use to evaluate your financial health.

A lower debt-to-income ratio tells the lender that you’re less likely to default since less of your income is dedicated to debt payments. Qualified mortgages require a debt-to-income ratio of 43% or less, and Beeston says that they typically look for a debt-to-income ratio under 45% for a conventional loan, though they may allow as high as 50% in certain circumstances.

It’s worth noting that refinancing to a 15-year mortgage will likely increase your debt-to-income ratio since you’ll be taking on higher monthly payments. So if your debt-to-income ratio is already high, you might need to take steps to reduce it — whether that’s increasing your income or paying off your other debt — before considering a refinance.

Understand your home equity

In addition to the credit and debt-to-income requirements, many lenders require you to have a certain amount of equity in your home in order to qualify for a refinance.

The amount of equity required varies based on the mortgage program you’re applying for, but conventional loans typically require 5%-20% equity while government-backed loans might allow you to refinance with 0%-10% equity.

In general, more equity will lead to more favorable mortgage terms. If you don’t currently have enough equity in your home, you may need to make some extra payments on your current mortgage before refinancing becomes a viable option.

Refinancing to a 15-year mortgage vs. making extra payments on your current mortgage

Landes argues that one of the biggest benefits of making extra payments toward your current mortgage is the flexibility it offers.

“Paying off debt faster is almost always a good idea, but refinancing permanently increases your mortgage payment which removes some flexibility from your family budget,” Landes said.

Landes also points out that a refinance comes with closing costs, which along with the reduced flexibility, could argue against going that route.

“Because principal reduction would be the same either way,” he said, “you should consider whether the lower interest rate on the refinance saves enough money to offset the closing costs of the new loan.”

The big downside to simply making extra payments on your current loan is that they may not be as consistent if you aren’t obligated to make them. If you are only making extra payments here and there, you won’t save as much money over the long term as you would with a 15-year refinance.

You also won’t get the benefit of a lower interest rate, which means that your total interest cost may end up being higher.

While you will have to run the numbers for yourself, here’s a table that compares the costs of each option for our example loan:

The bottom line: Should I refinance to a 15-year mortgage?

If your other financial priorities are already on track, you’re confident that you can handle the increased monthly payment for the foreseeable future and you plan on staying in your home for at least a few years, then a 15-year refinance could make a lot of sense. Securing a lower interest rate and shortening your repayment period could save you a lot of money over the long term.

But refinancing also comes with upfront costs and a loss of flexibility. And if it would make it harder for you to make progress toward your other financial goals, the long-term savings may not be worth it.

In the end, it’s a decision that should be made within the context of your entire financial situation.