REAL ESTATE TOPICS...Ask These 5 Questions Before You Refinance to a Shorter Mortgage

By DEBORAH KEARNS
You might think that refinancing your mortgage to a shorter-term loan is a win-win: You save on interest and pay off your home sooner. But many mortgage experts say there are better ways to invest extra money you might have than putting it into your home.

After all, paying off your home is just one of many important financial goals. You also need to save for retirement, put money aside for college if you have children, and buy life insurance, to name just a few. These may pay off in ways that make them wiser investments than paying down your mortgage faster.

Sometimes sticking with a longer-term loan just makes more sense: The tax benefits of the mortgage interest deduction last longer and you’ll almost certainly have a smaller monthly payment, leaving more cash on hand to help you reach those other goals.

Don’t get us wrong: Refinancing to a shorter-term loan might be a great move if you have extra cash and a stable job situation, but remember, your mortgage is just one piece of your personal-finance pie.

To figure out whether paying your home off sooner makes sense for you, ask yourself these five questions:

How much will my monthly payment be?

For some homeowners, especially those who have young families or who are cash-strapped for other reasons, squeezing an extra few hundred dollars out of the monthly budget and limiting access to ready cash isn’t advisable, says Michael Dunsky, branch manager of Guaranteed Rate in Franklin, Massachusetts.

“The first question I usually get from borrowers is, ‘What’s the lowest rate I can get?’ ” Dunsky says. “The answer is always a shorter-term loan, but the mortgage payments are about 25% higher on a 10-year fixed-rate loan, for example, than a 30-year loan. That’s not sustainable for a lot of people.”

Also, if you want to refinance to a shorter-term loan, your debt-to-income ratio must be low enough to prove to a lender that you can afford the higher monthly payment. For most loans, your DTI should be no more than 36%, according to Fannie Mae. Keep in mind that lenders include all your debt when calculating DTI and will hit you with a higher rate if you have a high ratio. So if you have a lot of credit card debt or a sizable car payment, prepare yourself for a higher mortgage rate.

Will I be able to meet my other financial goals?

A mortgage refinance to a shorter-term loan may work if you have few long-term debts and you have enough money coming in each month to pay all of your bills (with extra cash to spare). But if your budget is tight or you’re not paying attention to other savings, putting more money into your home could mean you’re selling yourself short, says Craig Strent, CEO of Apex Home Loans in Rockville, Maryland.

“When you invest outside of your home there are additional tax benefits, and you’ll have more liquidity,” Strent says, adding that you’ll also build wealth more quickly this way.

Rather than building equity in your home faster, it might make better financial sense to put that money to work in other ways, such as a 529 college fund, retirement and brokerage accounts, life insurance policies, and savings funds for big purchases down the road (vacation home, anyone?).

Is being completely debt-free a priority for me?

It used to be that people stayed in one house for the long haul and aimed to own it free and clear. (Oh, and they paid off their credit cards every month and had little to no student loan debt. Those were the days, huh?)

You’ve probably heard finance experts tout the debt-free philosophy in books and on TV. Although being debt-free is an admirable goal, it’s not always practical when you take into account increases in the cost of living, limited income growth and fluctuating property values, Dunsky says.

“When you invest more money into your home, you won’t be able to tap into that equity until you sell or refinance,” Dunsky says. “Figure out whether you can do all the things you want to do with your money without relying on your home’s equity. If the answer is ‘no,’ then a shorter-term loan probably isn’t the way to go.”

How long have I lived in my home, and do I plan to stay?

Depending on how far along you are on repaying your mortgage — and how long you plan to stay in your home — moving to a shorter-term loan can be an expensive mistake.

Mortgage payments are front-loaded with interest. So if you’re on year 18 of your mortgage, for example, you’re likely paying more toward your principal than interest at this point. If you refinance to a 10-year loan, you’ll pay more in interest upfront, Dunsky says, and you might actually lose money once closing costs and refi fees are taken into account.

Also, the average first-time homebuyer plans to stay in the home for just 10 years, according to the 2015 National Association of Realtors Profile of Home Buyers and Sellers survey.

If you plan to stay in your current home just a few more years, refinancing to an adjustable-rate mortgage at a five- or seven-year term will save money overall, Strent says.

With an ARM, your interest rate stays the same for the first few years. After that initial fixed-rate period ends, the rate can adjust up or down annually over the remaining life of the loan. You’ll need a larger down payment to qualify for an ARM, but it provides the stability of a fixed-rate mortgage for a set time at a lower cost than many other loan types.

Strent notes that a lot of first-time homebuyers overpay tremendously on their loans. Why? They stay in their homes for a relatively short time, so they could have used lower interest rates with an ARM rather than having paid more with a 30-year fixed-rate loan.

Can I pay my loan off faster in other ways?

Refinancing isn’t the only way to shorten your mortgage. You can simply pay more each month without committing to a shorter-term loan.

One approach is to take your current mortgage payment, divide it by 12 and add that amount to your monthly payment, Dunksy says. (Be sure to note that the extra amount is to go toward principal, not interest.) If you make those additional payments consistently over time, you could pay off your mortgage in 23.5 years instead of 30, he adds.

Or, you could have your mortgage broker crunch numbers on what the payments would be on shorter-term loans and simply make those exact payments each month without going through the motions of refinancing. If you’re short on cash some months, you can simply revert to your standard payment amount without the risk of penalties, Dunsky says.

Strent offers this tip: If you can afford only one extra payment each year, make January’s payment before Dec. 31 to get the interest counted toward the current year’s interest deduction on your tax bill. You’ll realize the savings now rather than later, which adds the instant-gratification factor.

Whatever you do, both Dunsky and Strent agree that going on a biweekly schedule (paying your mortgage every other week) is a bad move; the penalties are stiff if you miss a payment, and there are setup fees.

Bottom line

There’s really no one-size-fits-all formula. Ask yourself the five questions above to weigh the pros and cons of moving to a shorter-term loan against your overall financial goals.

Then, sit down with a mortgage broker who can run the numbers to see if you have what it takes for a shorter-term mortgage, or if another solution is better for you.