A 15-Year Mortgage Isn't for Everyone

MarketWatch

 

More homeowners turn to shorter loan terms

A growing number of homeowners are choosing to pay down their mortgages at a faster rate -- even if it means a substantial jump in their monthly payments.

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From January through June, 26% of homeowners who refinanced chose a 15-year fixed-rate mortgage, according to data from CoreLogic, a provider of financial, property and consumer information. During all of 2009, 18.5% of borrowers who refinanced opted for a 15-year term. About 9.4% did so in 2007.

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What's prompting the shift to shorter loans? Historically low interest rates for fixed-rate mortgages.

Homeowners are doing the math and realizing that rates have fallen enough so the increase in payment between a new 15-year mortgage and their current loan is no longer unbearable for their budgets, said Bob Walters, chief economist at online lender Quicken Loans.

The average rate on a 15-year fixed-rate mortgage was 3.86% for the week ending Aug. 26, according to Freddie Mac's weekly survey of conforming mortgage rates.

A Change in Thinking

The financial situation of the people capable of refinancing today is a factor in the shift, Walters said. These people typically are homeowners with the best credit and the most equity -- and, therefore, most suited for a shorter-term loan.

[See a Good Time to Double Down on Your Home?]

But there might be some psychology at work. "We're seeing a different view on debt than maybe we've seen in the past," he said. Today, homeowners are saying, "I really want to pay this off. I'm going to bite the bullet and take the payment and work toward paying this down."

Also, the average rate on a 15-year fixed-rate mortgage is below 4% right now, and having a mortgage rate that starts with a "3" is attractive for people who can afford it, said Leif Thomsen, chief executive of Mortgage Master, a privately owned lender.

It also acts as somewhat of a forced savings account for homeowners, he said, given that the higher payments help pay down the principal at a quicker clip.

This is a huge shift in borrower thinking. "There was a drive a couple of years ago to take out the biggest mortgage that you could and use all of the money you would have otherwise had in the house and put it into stocks and bonds -- to think of your house and mortgage as part of your entire investment portfolio," said Amy Crews Cutts, deputy chief economist for Freddie Mac.

"That worked for people who do investment finance for a living and are good at managing accounts," she said. "But for the average person, debt is a drag on their psyche as well as their overall budget."

Many Americans have reverted to the goal of paying off their house and getting rid of their mortgage, Cutts said.

Doing the Math

Refinancing into a shorter-term mortgage isn't a strategy for everyone, however.

Choosing a shorter term usually means you'll get a better rate -- and you'll pay much less interest over the life of the loan -- but a shorter timeframe ramps up monthly mortgage payments.

[See How to Overcome Refinancing Hurdles]

For example, with a 4.5% interest rate on a 30-year fixed-rate mortgage of $200,000, you would have a monthly payment of $1,015, including principal and interest, Cutts said. The monthly payment jumps to about $1,480 with a 4% interest rate on a 15-year fixed-rate loan.

Of course, if the refinancing borrower's current 30-year loan has a higher rate, the difference between the monthly payments could be less. Still, you should count on some increase in monthly payments.

In general, Walters said, those who choose 15-year fixed-rate mortgages are older and have more equity and less debt than other folks. They also earn higher incomes and don't have some of the added expenses that younger homeowners typically do.

"People who are taking these loans are financially stable and can afford the payments, but at the same time are planning on staying in their home for an extended period of time," Thomsen said.

Walters said homeowners shouldn't take on a 15-year fixed-rate mortgage unless they have substantial savings, including at least a year's worth of living expenses in liquid accounts.

Also, he recommends having a debt-to-income ratio below 35%. So if you have a gross salary of $5,700 per month, for instance, your monthly debt -- including any mortgage payments, taxes, insurance, homeowners-association dues as well as auto and student loans and credit-card debt -- would have to be a max of $1,995 to get a 35% ratio.

Make That Extra Payment

Borrowers who don't meet those standards, or are worried about future loss of income, might be better served taking a longer-term mortgage but making extra payments to the principal to pay off the loan faster, Walters said.

For instance, if you refinance a $200,000 mortgage into a 30-year loan with a 4.5% rate, and then apply $100 of the savings to the principal payment each month, you'd save $31,700 in interest over the life of the loan, Cutts said. And you would pay off the mortgage in 25 years, instead of 30, she said.

What's more, you would have the flexibility of not paying that $100 in months when money gets tight. "Maybe today you're feeling flush with money. Maybe you're worried in the future that income might change," Cutts said. With a 30-year mortgage, you have more flexibility. "Shortening to 15 years is a pretty big bump in payment."

Amy Hoak is a MarketWatch reporter based in Chicago.

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