Should You Refinance into a Shorter Term Mortgage?

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Should you refinance into a shorter term mortgage?

When mortgage rates are high -- and in December 2023, the rate for a 30-year mortgage loan was at 6.66 percent, while the 15-year fixed-rate mortgage loan was at 6.06 percent -- it might be best to refinance to a shorter-term mortgage so you can save tens of thousands of dollars.

When rates are high, just make sure that you can afford a higher monthly payment that fits within your budget.

The Impact of Mortgage Interest

When you pay your mortgage bill each month, much of your payment goes toward interest. In fact, during the earlier years of your mortgage, most of your monthly payment will be used to pay interest.

Interest is important and serves as the basis of the mortgage-lending industry. It is how mortgage lenders make their money and cover their risk when lending hundreds of thousands of dollars to homeowners.

However, mortgage interest can also cost homeowners hundreds of thousands of dollars during the life of their mortgage. For example, if you have a $200,000 fixed-rate 30-year mortgage with an interest rate of 6.66 percent, you will pay $262,691 in interest alone if you take a full 30 years to pay off the loan.

That is a lot of money spent on interest. However, if you took that same 6.66 percent loan and changed it from a 30-year to a 15-year term, you would pay just $104,957 in interest over the 15-year repayment period. That is a saving of more than $157,734 in interest payments.

The Challenge

Of course, the challenge of taking out a 15-year fixed-rate mortgage comes in the form of a higher monthly payment. Because the payback period for a 15-year loan is shorter than a 30-year loan, you will pay more each month. For instance, with a $200,000 15-year fixed-rate mortgage loan at an interest rate of 5.52 percent, you would pay about $1,636 a month. However, if you took that same $200,000 loan but a 30-year term, you would pay just $1,234 a month.

For many homeowners, the higher monthly payment that comes with a 15-year fixed-rate mortgage will price it out of their budgets, despite the interest savings such a loan brings.

However, when mortgage interest rates are low from a historical perspective, the equation changes. Depending on the rate of your 30-year fixed-rate mortgage, you could refinance to a 15-year fixed-rate loan and enjoy the savings in interest while making a monthly payment that isn't that much higher than your current one.

Low Interest Rates

Consider the 30-year fixed-rate mortgage for $200,000 at an interest rate of 6.66 percent. Again, the monthly payment for that loan comes to about $1,655. If you took that same amount and refinanced it to a 15-year loan with a rate of 6.06 percent -- the average rate in late December 2023 --, your payment would be $2,064 a month.

That is just $409 more a month, or $4,908 more a year than you would have paid with your 30-year fixed-rate loan. That might seem like a lot but consider the interest savings. The 15-year fixed-rate loan at an interest rate of 6.06 percent would require you to pay a total of about $104,957 in interest if you took a full 15 years to pay back the loan. That is a lot less than the $262,691 worth of interest payments you would make with the 30-year fixed-rate loan at 6.66 percent interest.

If you want to reduce the amount of interest you'll pay during the life of your mortgage, maybe it is time to investigate the benefits that come from refinancing to a shorter-term home loan. True, you will have to make a larger monthly mortgage payment. It is also true that you'll have to review your household budget to determine if that mortgage payment will fit. However, if it does, you stand to save potentially tens of thousands of dollars in mortgage interest.

While it is true that mortgage interest is how mortgage lenders and banks make their money, you should look to minimize what you pay out in terms of interest payments. Crunch the numbers to see if a shorter-term mortgage loan makes sense for you.

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