If you’re considering ways to save on long term interest and paying down your mortgage balance sooner rather than later, refinancing to a shorter loan term is probably the most common way to do so. Most mortgage loans issued carry terms of 30 years and the most popular is the 30 year fixed rate loan, especially when interest rates are at relative lows. Borrowers choose the 30 year loan to get a competitive rate but to also keep the monthly payment as low as possible. The longer the term, the lower the monthly payment. Yet over that longer term there is much more interest paid to the lender. You get a lower payment but the lender gets more money.
The sooner your loan is paid off, the more money you will save not only on interest but your cash flow each month is significantly improved when you’re “mortgage free.” And there are some ways to pay down your mortgage sooner rather than later.
Looking to Shorten Your Loan Term? Try Direct Paydown
The easiest way to pay off a mortgage is to make direct payments to the loan amount, either in a lump sum or paying a little extra each month. When you make an extra payment to a fixed rate loan you’re shortening the loan term. When you make an extra payment on a variable rate loan you’re lowering the monthly payment because the payment is recalculated at each adjustment period based upon the rate and the outstanding loan balance.
There is also a “bi-weekly” option which allows borrowers to make a mortgage payment every other week instead of once a month. This arrangement is set up by the lender and in essence is equivalent to making 13 payments per year instead of 12. You can set up a bi-weekly plan but you can do the very same without enrolling in one by making an extra payment each month equal to one-twelfth of your payment. This also equates to 13 payments per year.
Rate and Term
Another way to become mortgage-free sooner is simply to refinance into a shorter loan term. That makes sense for many if current market rates are lower or even the same. A shorter loan term will have higher payments compared to a longer term loan but if current market rates are low enough to offset the higher monthly payment it can make sense to contact your loan officer and refinance to a shorter loan term while keeping your monthly payment about the same, or even lower.
This is a simple rate and term refinance where there is no cash taking out during the transaction and the rate and the loan term are adjusted. There are multiple scenarios for this method as loan terms can range from 10 to 30 years in five year increments. Instead of refinancing a 30 year loan into a 15 year, have your loan officer run some numbers for perhaps a 25 or a 20 year term. Remember, the shorter loan term saves on interest and you’ll be mortgage free in less time.
If you refinance a 30 year loan into another 30 year loan take into consideration how long you’ve had your current mortgage. If you’re five years into a 30 year loan and refinance into another 30 year loan you’ve essentially taken out a 35 year mortgage. Even if the new rate is lower than the old one, you’ve just added five more years of interest.
A Different Take
Here’s another way to shave years off your mortgage by refinancing. Instead of simply refinancing to get a lower rate and a lower monthly payment, get a lower rate and continue to make the old payment. Remember, any extra goes toward the principal balance, paying off your mortgage. The interest rate change can be as little as 0.25% lower yet still be effective.
Doesn’t the interest rate have to change more than 0.25% to make a refinance worthwhile?
Let’s say you’ve got a 30 year mortgage with a balance of $200,000 and a 5.50% rate. The principal and interest payment is $1,135. A couple of years later the rate falls to 4.75% and the loan balance is $191,452 and you refinance. The new monthly payment is $998, or $137 lower. You might be asking about the closing costs. You’re saving $137 but we forgot about the four or five thousand dollars in closing costs. But with this strategy the lender pays the closing costs for you in exchange for a slightly higher interest rate on the new note. Lower rates were available when you locked in the 4.75% rate but the lender couldn’t pay for your closing costs. This is key for this strategy to work effectively. You must get a “no closing cost” loan and don’t add anything to your outstanding principal balance.
The second key ingredient is to continue making the older payment of $1,135. Each month, the $137 extra goes to the loan balance, not in your pocket. Now say three years later the rate is 4.25% and your loan balance is $165,917. You refinance yet again at 4.25% and your monthly payment is $816 but you continue to pay $1,135, or $319 more. You can see what’s happening here, right? Each month you’re paying the same amount and the extra is going to the outstanding loan balance paying down your mortgage much faster. How fast? If you stopped refinancing at this point your loan term is reduced from 30 years to 17.
This does take some commitment and the extra payments must be made each month for this strategy to work to its full potential. And at the same time, should something come up that causes you to not make the full payment one month that’s okay, you can skip one month or make it up the next. It’s completely up to you. Just remember, the rate should be lower than what you currently have, even if it’s just 0.25% lower. And, don’t add anything to your loan balance when refinancing, just refinance the outstanding balance. This strategy is one of the lesser known but is extremely powerful. Run some numbers with your loan officer and we think you’ll agree.
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