Pros and Cons of Refinancing into a Shorter Loan Term

How long is the typical mortgage? The usual answer is 30 years and with good reason: Monthly payments with a 30-year term are affordable for most borrowers.

That said, some borrowers can do better – much better – refinancing with shorter mortgages, loans that can create six-figure savings in some cases.

Refinancing and Lower Interest Costs

To see how the loan term impacts monthly payments let’s look at a $300,000 mortgage at 6.5%.

• Over 30 years the monthly payment for principal and interest is $1,896. The potential interest cost for a $300,000 mortgage at 6.5% over 30 years is $382,632.
• Reduce the term to 15 years and the monthly payment jumps to $2,613. However, the potential interest cost falls to $170,398.

How much can a borrower potentially save by financing with a 15-year mortgage? More than $210,000 ($382,632 less $170,398).

Shorter Loan Terms Mean Lower Rates

Lenders want loans that combine the least possible risk with the best possible return. One of the issues they consider is the loan term. The longer the loan the greater the risk.

Of course, when risk goes up so do interest rates. The same principle applies when risk goes down. In that case rates fall.

When borrowers shop for 15-year financing they’re likely to find that rates are lower than 30-year mortgages. How much lower depends on such factors as the borrower’s financial profile, market trends, and the borrower’s ability to negotiate.

For the sake of illustration – and remember that your number may differ – let’s say the discount is .625%. 

• Over 30 years the monthly payment for principal and interest is $1,896. The potential interest cost for a $300,000 mortgage at 6.5% over 30 years is $382,632.
• With a 15-year term we can borrow $300,000 at 5.875%. The monthly payment is $2,511 and the potential interest cost is $152,045. 

When we compare the two loan options we can see that in our example the 15-year loan will save a borrower more than $230,000 over the loan term when compared with 30-year financing. ($382,632 less $152,045).

Why Refinance Today if Mortgage Rates Have Risen?

“Over the last decade,” said the National Association of Realtors in April 2023, “the median-priced home has become worth about $190,000 more.”

Because of the equity surge, many homeowners now have significant equity, equity that can be used to start a business, pay for tuition, or eliminate higher-cost debt. And although mortgage rates have risen, the important point is that they may lead to less expensive borrowing when compared with other forms of financing.

What About Monthly Costs?

A shorter loan term means a higher monthly cost. In our example, the cost for 30-year financing is $1,896 a month versus $2,511 for the 15-year loan, a difference of $615 a month.

The monthly cost differential between 30-year and 15-year financing means that short-term financing is simply not an option for many households. However, the severe labor shortages seen in many fields as a result of the pandemic means that many workers are seeing higher wages and salaries.

For many households this means more income and expanded affordability. 

The Pass-Through Effect

So far we have looked at interest comparisons based on the full length of a loan, either 30 or 15 years. The reality is that few mortgages are held for their entire term.

In most cases they end as a result of refinancing, because they were paid off, or a property sale. In fact, the National Association of Realtors reports that in 2022 “sellers typically lived in their home for 10 years before selling.”

However, short-term mortgages do not have to be held to term in order to produce benefits. You can see this with an apples-to-apples comparison.

• After five years, a 30-year mortgage for $300,000 at 6.5% has a remaining loan balance of $280,833.
• After five years, a 15-year mortgage for $300,000 at 6.5% has a remaining loan balance of $230,151.

In our example, even with identical interest rates, if the home is sold after five years the borrower with the 15-year mortgage will get an additional $50,000 at closing when compared with someone who used 30-year financing ($280,833 less $230,151).

The money saved with a short-term mortgage can make the next home more affordable or simply give the borrower more cash on hand.