Should You Refinance to a Shorter Term Mortgage?

Refinancing your mortgage to a shorter term might seem like an obvious choice for many homeowners. It's easy to think that paying off your home faster and saving on interest costs is a good idea. But it may not be that simple.

Refinancing may result in higher finance charges over the life of the loan. So, let’s break down what refinancing to a shorter mortgage term really means and if it is a good idea for you.

The VA offers an Interest Rate Reduction Refinance Loan (IRRRL) option, which is great for existing VA loan holders wanting to save and take advantage of lower interest rates. Veterans United offers VA IRRRL refinances in 15, 20, 25 and 30-year terms.

However, refinancing to a shorter term isn’t for everyone. Most of the time, your monthly mortgage payments will increase since you have a shorter timeframe to pay off the loan. This could be a significant financial burden for those who can’t afford a higher monthly payment.

Let’s take a look at the pros and cons of refinancing to a shorter term.

Pros of a Shorter Mortgage Term

VA loan interest rates are typically lower when you’re opting for a shorter loan term, although the spreads can vary depending on the lender and the lending climate. Take a closer look below at the pros of refinancing to a shorter mortgage term.

Lower Interest Rate

Refinancing to a shorter mortgage term can often lead to an immediate benefit of a lower interest rate. Lenders typically offer lower rates on shorter-term loans because they are taking on less risk. The quicker you repay the loan means there's less time for something to go wrong, like a market downturn or the borrower's financial instability.

A lower interest rate is not just advantageous for the obvious immediate reduction in interest costs but also the contribution to a more efficient debt management strategy. With a lower rate, each payment you make has a greater impact on reducing your principal balance, which can be particularly beneficial for homeowners looking to improve their financial standing in the shorter term. This strategy shifts the focus from long-term interest savings to the immediate financial flexibility and efficiency gained by securing a lower interest rate through refinancing.

Interest Savings

One of the most significant benefits of refinancing to a shorter mortgage term is the potential for substantial interest savings. By choosing a shorter loan duration, you can cut down the total interest paid throughout the life of the loan.

These savings stem from two key factors: shorter-term mortgages typically attract lower interest rates than their longer-term, and the shorter repayment period also means interest accumulates for less time.

Consider a 30-year mortgage vs a 15-year mortgage. Even if the interest rates were the same, the total interest paid on the 30-year loan would be significantly higher because the interest is being applied over a longer period.

To get an idea of how substantial those savings might be, let’s compare two scenarios:

As you can see, refinancing from a 30-year loan at a 6.5% interest rate to a 15-year loan at a 6% interest rate can result in significant interest savings over the life of the loan, specifically amounting to $226,950.78 for this example.

Build Equity Faster

Refinancing to a shorter mortgage term is also an effective strategy for building home equity quickly. When you switch to a shorter loan term, your monthly payments might be higher, but a larger portion of these payments goes towards reducing the principal rather than just covering the interest.

As the principal decreases more rapidly, your equity builds up faster. This not only strengthens your financial stake in your property but also positions you better for future financial opportunities, such as obtaining home equity loans, lines of credit or selling the home at a profit.

Maximize Your Mortgage-Free Years

For some homeowners, the freedom of owning a home outright outweighs the monthly expense of making a 15-year mortgage work. With a shorter mortgage term, you can redirect those funds for a monthly mortgage payment to savings or retirement, travel, or even turn your home into an income property.

With a shorter term, you won’t have to wait until later in life to reap the benefits of living mortgage-free.

Cons of a Shorter Mortgage Term

While refinancing to a shorter mortgage term offers several benefits, it's important to consider the potential drawbacks before making a decision. This shift may introduce some financial challenges and limitations that homeowners should be aware of.

Higher Monthly Cost

While shorter loan terms are considered a lower risk for lenders and investors, they may represent a higher risk for homeowners based on month-to-month affordability. When you shorten the term of your mortgage, you're committing to pay off the same loan amount in a shorter time period. Even if you secure a lower interest rate, the requirement to pay down the principal more quickly means each monthly payment will be larger.

For homeowners with tight budgets or fluctuating incomes, this increase could strain their financial resources, potentially limiting their ability to manage other expenses, save for emergencies or invest for the future.

Temporarily Lowers Credit Score

When you apply for refinancing, lenders perform what is known as a 'hard inquiry' on your credit report to assess your creditworthiness. This inquiry can cause a small and typically short-term dip in your credit score.

Also, closing your old mortgage and opening a new one adds new activity to your credit history, which can also temporarily affect your score. It's important to note that while these dips are usually minor and recoverable, they can be more pronounced if you have multiple credit applications within a short timeframe.

It's advisable for homeowners to plan their refinancing and other credit applications strategically to minimize the impact on their credit score.

Less Budget for Savings

While the shorter term accelerates building equity and reduces the overall interest paid, it does demand a larger portion of your monthly budget. This can leave less room for emergency funds, retirement accounts or other savings.

Especially for those who are balancing various financial goals or have fluctuating income, the higher payments with a shorter mortgage term might limit their ability to save and invest for other long-term objectives.

Closing Costs

One significant downside of refinancing can be the associated closing costs. These costs can include a variety of fees, such as appraisal fees, origination fees and title insurance. These expenses must be paid upfront, either out of pocket or by rolling them into the new loan amount, which can negate some of the financial benefits of refinancing.

It's important to consider the breakeven point – the period it takes for the savings from refinancing to outweigh the costs. While the overall interest savings can be significant, it might take several years to break even due to the high upfront costs.

When Refinancing to a Shorter Term Makes Sense

Deciding to refinance to a shorter mortgage term is a decision that depends on several factors. It’s important to consider if you can comfortably afford a higher mortgage payment. Your future housing plans are also important; if you are planning to move soon, refinancing might not be the best choice due to the time needed to recoup the costs. Lastly, shorter loan terms may mean fewer mortgage interest deductions on your taxes, which can have a significant impact on your overall financial planning.

Overall, refinancing to a shorter term makes the most sense when you are in a stable financial position to afford higher payments, intend to stay in your home long enough to offset the closing costs and have a clear understanding of how this change will affect your tax situation.