The pros and cons of refinancing to a 15-year home loan

Homes & real estate
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The pros and cons of refinancing to a 15-year home loan

Homes & real estate

As a homeowner, you must have done the math at some point: “Let’s see, I paid X dollars for my house, but by the time I pay off the loan it’ll actually cost me… add the 7… carry the 2… multiply by 30… Wow. That’s a lot more dollars. And if you haven’t done the math here it is: the interest on a 30-year mortgage can easily add hundreds of thousands of dollars to the final cost of your home. As an example, the total cost of a $240,000 loan at 4.25% interest after 30 years will actually run you $425,036. Once you’ve done the math, you’ve probably asked the question, “What if I refinanced with a 15-year home loan instead? I may be a few years into my current loan, but I’d probably still save a boatload in interest.”

And you’d be correct. A 15-year loan at that same 4.25% would only run you $324,984 by the time you're done. A savings of just over a hundred grand. You wouldn’t save quite as much with a refi, but 80-60%—even 40%—of 100K is still a big number for most Americans.

So why doesn’t everyone jump on the 15-year bandwagon? It’s a no-brainer. Right?

Let’s take a look.

Opportunity Cost

An “opportunity cost” is “the loss of potential gain from other alternatives when one alternative is chosen.”

So, using the above example your monthly payment on a 30-year loan would be $1,181. On a 15-year loan: $1805. That’s over $600 a month you don’t have for 180 months.

By opting to put more money towards paying off your mortgage, you lose the ability to apply that money to such things as:

  • Other investment vehicles such as a 401(k) or an IRA which might offer significant tax advantages when you retire.
  • Paying off other higher-interest debt such as credit cards (which pretty much every financial planner on Earth will tell you is the smarter way to go).
  • Upgrades or repairs to your house which would increase your equity.
  • Nice things: a fancier vacation every year, or a new car lease every two years, or a summer cabin. Maybe you value the quality of your lifestyle over maximizing the size of your bank account.

Costs of Opportunity

With a 15-year loan you’ll not just pay much less in interest over the life of the loan, but in the initial loan rate, too. 15-year home mortgages can be as much as three-quarters of a percent lower than a 30-year loan. Using our example again, a $240,000 loan at 3.85% instead of 4.25% will put the total cost of the loan at $316,308. That’s an extra eight grand in savings.

However, the costs of a refinance run anywhere from 2-5% of the loan value, so you might not see much, if any, of that extra savings.

20/20 Foresight

Where are you in your life and what might happen in your future?

If you’re in your 20s and this is your “starter”, home, sticking with a 30-year loan might be better because you’re still on the upward portion of your earning curve. You may simply not have the income to afford the higher payments—the most obvious drawback to a 15-year loan.

On the other hand, if you’re in your 50s, having your home paid off at the same time you retire might be a load off your mind and your monthly budget.

Having all of your savings and the bulk of your income tied up in one of the least liquid assets there is will have you in a bind should your six-year-old car not make it to seven or your kids suddenly need help paying their tuition.

Do you work in an industry that regularly sees boom and bust cycles? Extra equity won’t put food on the table or keep the lights on.

Grasshopper vs. Ant

Then there’s a third possibility between 15- and 30-year loans: overpayments.

Remember, your payment is simply the minimum amount that must be paid each month. There’s nothing that says you can’t voluntarily pay more.

If you go this route you’ll be able to overpay when your budget allows and stick to the minimum when things are tight.

Obviously, you’ll want to make sure your loan agreement doesn’t carry any pre-payment penalties or limit how much you can overpay without resulting in a fee. And you’ll want to make sure your payments are applied to the principal and not interest so you can reduce that faster.

Whether this is right for you depends on whether you have the financial discipline to make the higher payment every month or if it’d be easier for you to be on a set payment schedule.

Dollars and Sense 

A 15-year refinance offers an excellent opportunity to save big in the long run, but it’s not the best choice for everyone. Take a good, hard look at your present financial condition and where you’ll most likely be in the future to determine if it’s an option you can exercise today or if waiting a bit will pay off more.