I frequently hear from my clients asking for advice about re-financing. They are considering re-financing to a 15- or 20-year note in order to pay their home loan down more quickly, build equity faster, and because interest rates on shorter term loans are typically lower (especially 15-year notes) than 30-year notes. 15-year notes are great if you can afford them because you pay down nearly 3x the principal each month compared with a 30-year note payment. However, here are a few other things to consider in your decision-making process:
Debt-to-Income Ratio: Your DTI will be negatively affected because your required monthly payment will be higher with a 15-year note. So if you have ambitions to invest in other real estate in the future, you could be adversely affecting your ability to qualify for another real estate loan by increasing your DTI Ratio closer to max limits for Conventional loans.
While the higher monthly payment associated with a 15-year note might be comfortable today, what happens if you have a life change—lose a job, have an accident and can’t work for a while, spouse decides to go back to school for a career change, get a divorce, etc? Having that lower monthly payment associated with a 30-year note will be much more comfortable in that situation.
Anytime you re-finance and “roll the closing costs” back into the new loan, you are increasing the overall principal owed. The breakeven period to recover from this and realize the benefits of the new loan terms is often 3-7 years.
As an alternative, consider making extra payments on your 30-year note. Most mortgage loans do not penalize you for early or extra payments. And consider this math:
• If you make 1 extra payment annually (Principal + Interest only, not including escrows), your loan term will shorten to 25.5 years.
• If you make 2 extra payments annually (P&I only, not including escrows), your loan term will shorten to 22.5 years.
• If you make 3 extra payments annually (P&I only, not including escrows), your loan term will shorten to 20 years.
• If you make 6 extra payments annually (P&I only, not including escrows), your loan term will shorten to 15 years.
Now, you might say “gosh, 6 extra P&I payments per year sounds like a lot!” But the difference in your monthly payments for a 15-year note vs 30-year note, multiplied by 12 months, equates to about 5 month’s worth of P&I payments on the 30-year note. So, there’s not much difference!
In my experience and opinion, it’s better to keep your DTI Ratios lower (especially if you are a real estate investor or have aspirations of being one) and make elective extra payments monthly or annually rather than potentially handcuff yourself with higher required monthly payments on a 15-year note.