Which Loan Term Is Right for Your Refinance?
When you’re refinancing a mortgage, the length of your loan term will significantly impact how much it costs. That being said, there’s no “best” refinance term — the length of the loan you should choose depends on your short- and long-term financial goals, which will be different for everyone.
Here are some things to think about and do when choosing a loan term for your refinance:
- Loan terms and your financial plan
- Compare loan terms
- Pros and cons of a longer loan term
- Pros and cons of a shorter-term loan
- Other things to consider before you refinance
Loan terms and your financial plan
As discussed above, the best refinance terms should complement your long-term financial strategy.
Jerry Koller of International Home Realty is a mortgage broker who often handles client requests for refinancing. He says that these are some of the questions you should ask yourself when considering a mortgage refinance:
- Will the potentially higher payment be easy to make if there is an emergency?
- Does the cost of the refinance outweigh the benefits of refinancing?
- How much interest will I pay over the life of loans with different terms?
- Do I need to refinance, or can I save by simply making a larger monthly payment?
The loan term is just one of many factors to consider when deciding to refinance your mortgage. Before you start comparing refinance loans, make sure you’re familiar with the main cost drivers on your current loan, including:
- the original loan amount
- your remaining mortgage balance
- the remaining amount of time on your loan
- the interest rate on your current mortgage
- prepayment penalties you may incur if you refinance
You’ll also want to consider the cost drivers on a potential refinance loan, including:
- the new loan amount you want
- the interest rate
- closing costs
- the loan term
- addition/removal of mortgage insurance, based on new loan-to-value ratio
- if you will paying points to get a lower interest rate
Once you are aware of all your current and potential costs, you should plug them into a refinance calculator to help you compare refinance options. Your short- and long-term goals will dictate which factors are most important.
For example, you may be primarily interested in reducing your monthly payment. A longer loan term may help you do that, and if you’re able to qualify for a lower interest rate, that could further decrease your monthly payment.
Alternatively, your goal may be to pay the least amount of interest on your loans as possible. You could refinance into a shorter term with a potentially higher monthly payment, but by paying your loan off in less time, you’ll pay much less interest. In this scenario, you’ll want to pay attention to your break-even point — when the amount of money you’ve saved from a lower interest rate makes up for any upfront costs (like points or loan fees) you paid to get that lower rate.
Everyone’s current mortgage situation and future goals are different, so it’s important that you understand what you’re working toward and the cost you are willing to pay to support these goals. This is how you will choose the right refinance term and ultimately loan offer.
Compare loan terms
You’ll notice that refinance loans with shorter terms have the lowest interest rate.
Corey Vandenberg, a mortgage banker in Lafayette, Ind., explains why interest rates on shorter loan terms tend to be lower: “There is nothing riskier than near 100% financing in the first few years of the loan,” referring to the early years of a 30-year loan when you’re paying mostly interest.
Vandenberg goes on to explain, “A 15-year, in contrast, pays down principal much faster, or better said, pays back the lender [faster], lowering the risk. So it gets a better rate.”
The table below shows you the difference in monthly payments for a $250,000 loan financed over varying terms. To keep the example simple, we assume:
- The amount refinanced will be $250,000
- Closing costs are rolled into the loan
- No down payment was made
- The borrower has excellent credit and qualifies for the best available rate
|Comparing Home Loan Terms – Monthly Payments|
|Term||Rate||Monthly Payments (principal + interest)|
These rates and monthly payments are examples — what you may qualify for and end up paying will depend on many factors including your credit profile, amount financed, loan-to-value ratio, closing costs, and other fees.
If you’d prefer a longer loan term to get a lower monthly payment, keep in mind you’ll end up paying more interest in the long run than you would with a higher monthly payment and a shorter loan term.
The table below illustrates how much interest you end up paying over the life of the loan for different loan terms.
|Comparing Home Loan Terms – Interest Paid|
|Term||Rate||Total interest paid during life of loan|
As you can see here, the term you choose will directly impact the amount of money you end up spending for your home.
Andrew Weinberg of Silver Fin Capital also adds that some loans seem ideal on paper, but aren’t always practical or easy to qualify for. “While it might sound attractive, the 10 year fixed […] comes with a much higher monthly payment,” he said, adding that the higher payment requires a higher income to qualify for it. “So it is rare for a client to even choose this option.”
|Pros and cons of refinancing into a loan with a longer term|
|Could get a lower monthly payment||Higher interest rate compared with shorter terms|
|Could get a lower interest rate than current mortgage||Pay more over the life of the loans|
|Have the option to pay down your debt faster by paying extra, but you’re not locked into a higher payment||Closing costs and additional interest payments may outweigh benefits of lower monthly payment|
|Pros and cons of refinancing into a shorter term loan|
|Pay off loan quicker||Higher monthly payment|
|Pay less interest over the life of loan||May not capture enough interest savings to justify closing costs|
|Lower interest rate compared with longer terms||No flexibility to pay less if you become strapped for cash|
|Build equity in your home faster||May be difficult to qualify for|
Other things to consider before you refinance
Before you pull the trigger on the term you’ll choose for your home refinance, you need to evaluate other factors like:
How long do you plan to stay in your home?
Say you buy points upfront so you can get a lower interest rate on your refinance. You need to calculate your break-even point: How long you need to stay in the home so your interest savings outweigh what you paid to get them. On the other hand, if you don’t plan on staying in the home for a long time, opting for short-term savings (like a longer loan term) may make the most sense.
Will fees, closing costs or other expenses make the term you choose more expensive than your current mortgage?
When you refinance, you’re taking out a new home loan — that means you’ll have to deal with many of the same expenses you had when you first bought the home, like closing costs. And depending on how much equity you have in the home after accounting for the new loan, you may have to pay mortgage insurance.
You could also see if a no-cost refinance makes sense. That means that instead of paying closing costs upfront, they’re added to your loan balance and financed over the length of the loan term. That will be more expensive in the long run, but if you’re focused on short-term savings, you may want to look into it.
With a shorter term, do you have the money in your budget for a higher payment?
Shorter loan terms may come with a lower interest rate, but that won’t do you any good if you can’t afford the monthly payment. You could get a 30-year term but make payments like it’s a 15-year loan, and by paying down the loan faster, you’ll save on interest and retain the flexibility to make lower payments.
Wildcards like a job loss, illness, relocation or anything else that could affect your income, tax bracket or ability to keep your home, can also play a major role in the ideal term for your refinance. Of course, you can’t predict the future, but having a backup plan for these scenarios should be considered when choosing a loan term. For example, this could mean having a larger emergency fund to cover higher mortgage payments.
What are the tax implications of a longer or shorter refinance term?
George Pantelaras of Planet Home Lending urges people to connect with their accountant if they will refinance their home. “Customers should check with their accountant or tax professional and work together with them to calculate how much mortgage interest can be written off. This figure will help with an overall financial strategy that considers tax, retirement and other life factors.”
Refinancing a home is a big decision, but if you do your homework and, at the very least, consider possible risks and set clear goals for what you want this refinance to accomplish, you should be equipped to make the right choice for a loan term. Run the numbers and just make sure that they make sense for your personal needs and financial objectives.