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Refinancing? Should You Move to a 15-Year Mortgage?

Record low rates luring many to choose shorter loan

by Karen Kroll, AARP Bulletin, June 23, 2010

With interest rates for 15-year mortgages at record lows, it’s not surprising that a growing number of homeowners are choosing to refinance with 15-year loans instead of the traditional 30-year. The payback for older Americans could mean paying off the mortgage before retirement, but there are some pros and cons to consider.

For Indianapolis-based Lauren Windle and her husband, both 55, refinancing their 30-year mortgage with a 15-year loan will help ensure that their home is just about paid off by the time they’re ready to retire. Although the interest rate on the new loan is about 0.75 percent lower, the new loan still will boost their payments by about $100 per month. In addition, the Windles are planning to make additional principal payments in order to whittle down their balance even more quickly.

While that means a bit of sacrifice—they’ve cut back on trips, dinners out and clothing purchases, for instance—it’s worth it, Windle says. “We expect to live a number of years, and want to make it as convenient and pleasant as possible. Better to bite the bullet now,” and not worry about finances later, she says.

For other people, like Wendy Sheridan of Rahway, N.J., a 15-year loan is a no-brainer. She and her husband refinanced a 30-year mortgage in late 2009. Sheridan, 52, had come into an inheritance, which allowed her to pay off about two-thirds of their previous mortgage. In addition, the couple was able to cut about 1.5 percent from their interest rate.

In the end, their monthly payments dropped by about $1,000, enabling them to put more toward retirement and college costs for their daughter in high school. And what’s more, Sheridan adds, “By the time the loan is paid off, it will be right around my retirement.”

But for those who can’t afford the higher monthly payments, a 30-year mortgage makes more sense.

John Sullivan, 64, who works in the real estate industry in Bethesda, Md., refinanced in the spring of 2009, but decided to stick with a 30-year term. “As a buyer’s agent, I work on commission, so my flow of income isn’t always consistent,” he says.

The longer loan offered some flexibility. Even so, Sullivan says he has been disciplined about bumping up each monthly payment by about 25 percent, and plans to continue doing that.

All in all, the low interest rates are helping attract a growing number of homeowners to 15-year mortgages. Such loans made up about 24 percent of all refinancing applications in April 2010, versus 13 percent one year earlier, reports the Mortgage Bankers Association.

Advantages of a 15-year mortgage

A lower interest rate. While almost all mortgage interest rates are low right now, interest rates on 15-year loans are even lower. In mid-June, the average rate on a 15-year fixed-rate mortgage was 4.16 percent, compared with 4.80 percent for a 30-year mortgage, reports Bankrate.com. The difference between the rates is significant, says Ethan Ewing, president of Bills.com, a consumer finance website.

But in calculating what you’d save, keep in mind that lower interest rates may mean you get less of a tax deduction on April 15. Your real savings are your lower interest payments minus higher taxes.

Lower total costs. The total amount of interest a homeowner pays over the life of a 15-year mortgage is, of course, much less than the total amount paid over a longer mortgage.

For instance, a homeowner can expect to pay a total of about $187,000 in interest on a $200,000, 30-year mortgage with an interest rate of 5 percent. Change the term to 15 years, and total interest charges drop to about $85,000, also according to Bankrate.com.

Peace of mind. Paying off a mortgage more quickly also offers a less quantitative, yet still important benefit, particularly for fifty- and sixtysomethings. “For some people, there’s a considerable psychological benefit to having a mortgage paid off when they retire,” says Michael Fratantoni, vice president of research and economics with the Mortgage Bankers Association.

Disadvantages

On the other hand, many homeowners shy away from 15-year mortgages. Here’s why:

Other debt. It makes sense to attack any credit card debt before shortening your mortgage, says Jason Lilly, director of portfolio management with Rockland Trust in Osterville, Mass. “After all, the interest rate for credit card debt is three to five times higher.”

The cost to refinance. Every refinancing transaction comes with costs, like appraisal and document preparation fees. To make refinancing worthwhile, the new interest rate should be at least 0.5 percent lower than the current rate, says Ewing. So, if you’re paying 5 percent, you’ll generally want to consider refinancing if the new rate is 4.5 percent or lower.

Also, you need to be fairly confident that you’ll be in your house for long enough after you refinance that you’ll recoup the costs. Say, if you save $200 a month by refinancing and have closing costs of $5,000, you’d want to stay at least two years.

Steeper monthly payments. In the example of a $200,000 house, the monthly payments on the 15-year mortgage come to $1,582—about $500 more than with a 30-year loan. People looking into a 15-year mortgage will want to make sure that their total debt-to-income ratio remains below 45 percent, Ewing notes. “That gives some wiggle room in case you lose income or your other expenses go up.”

However, if a homeowner already has been making payments for some time on a 30-year loan, the jump in the monthly payment isn’t quite as dramatic.

Again, take a 30-year loan of $200,000, and assume the homeowner has been paying on it for 10 years, leaving a balance of about $163,000. Refinancing to a 15-year mortgage bumps the payments to about $1,281, or a difference of $200. What’s more, that is assuming the homeowner’s interest rate stays at 5 percent; if it drops because the loan is for 15 years, the monthly payments will as well.

Karen Kroll is a Minneapolis-based finance writer and blogger. Her stories have appeared in Bankrate.com, CFO, CreditCards.com and other publications.