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4 reasons to shorten your loan term

Posted by  on Feb 06, 2013
 

Plenty of homeowners get excited about low interest rates on home loans and compete to get the lowest mortgage rates among their friends and colleagues. Rather than focus solely on the rate, however, you should consider how refinancing fits in the context of your overall financial plan. If you plan to stay in your home forever and your main goal in refinancing is to reduce your monthly mortgage payments, then a 30-year fixed-rate home loan is the right mortgage product for your needs. On the other hand, if you have other goals for your home loan, then you may want to consider reducing your loan term to a 20-, 15- or 10-year loan or even to an individualized loan term such as 7 or 11 years.

4 reasons to consider a shorter mortgage

While there are many reasons a shorter term may appeal to you, be sure to compare your monthly payments under different scenarios to make sure you can comfortably afford the payments and still fund your retirement plan and meet other savings targets. In the meantime, consider these potential reasons to shorten your mortgage term:

  1. Build equity faster: If you know you're moving in a few years and want to reap a nice profit from the sale of your home, you can build your equity faster if you pay down your loan more quickly. If you can afford the payments, you might want to take on a 10-year loan. When you sell in five years, your mortgage balance will be significantly lower than if you refinance into a 30-year loan.
  2. Pay off your mortgage in full. Whether you want to pay off your mortgage before you retire or before your kids start college, a short loan term will force you to eliminate the balance faster than if you attempt to make extra payments on the principal.
  3. Pay less in interest. A shorter loan term means that you can save thousands in interest payments over the life of the mortgage. For instance, if you have a $300,000 mortgage at 3.75 percent, you'll pay $200,165 in interest overall. If you switch to a 15-year home loan at 3.50 percent, you'll pay $86,037, a savings of $114,128. Of course, your monthly payments will be much higher on the 15-year loan: $2,145 compared to $1,389 on the 30-year mortgage. The payment shock won't be nearly as great, however, if you are refinancing from a higher interest into a mortgage with low interest rates.
  4. Get a lower interest rate. As you can see from the example above, mortgage rates are lower on shorter term loans. The gap varies from one-fourth to one-half or more between a 30-year fixed-rate loan and alternatives such as a 10-year loan or a hybrid ARM with a 5- or 7-year fixed-rate period followed by an adjustable rate.

Regardless of which home loan you choose, comparing interest rates and fees in the context of your overall financial plan can help you make a solid decision.

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