What loan term should you choose for refinancing?

Key Points

1. In general, refinancing to a shorter mortgage period helps you pay off the mortgage quicker and reduce total interest paid.

2. However, other conditions (a significantly lower interest rate, sudden need to lower the monthly payment etc.) can justify keeping the period the same or increasing the loan period.

3. It is important to consider all factors and prioritize your personal goals to make the decision, not just the impact of the period of the loan.

Context

As you consider refinancing your mortgage, one of the key questions you need to answer is: which loan term should you choose? If you already have a 30-year mortgage, should you keep it the same? Or go for a 15-year mortgage?

Unfortunately, there is no simple answer. It all depends on your situation, what your goals are, which option makes the most financial sense.

There are 2 key factors to make your decision: current mortgage period and time left in the mortgage. For this article, the assumption is that remaining time in the mortgage is more than 70% of the current mortgage period. (i.e. if you have 25 years left in a 30 year loan.)

Let’s explore the three options available to you and understand the pros and cons of each option.

Option #1: Refinance to the same loan period as your current mortgage:

You opt to refinance for the same loan period as your current. For example, you have an existing 30-year mortgage, and you refinance the mortgage to another 30-year period.

Pros:

1. Lower interest payment: If you take advantage of a significantly lower interest rate compared to your original rate, you could pay less total interest across the duration of the loan.

2. Lower monthly payment: If you take longer to pay back the remaining principal amount, you could pay less total monthly payment. This could help your cash flow.

3. Increase principal payment: If you continue to pay the same amount after you refinance to the new period, the extra payment can be applied to reduce the principal.

Cons:

1. Resetting the clock: You will be forced back to day 1 of the mortgage, further away from paying off the loan fully.

2. Slow equity build: As payments reset, you will pay more of the front-loaded interest than the principal. As less money will go towards paying down the principal, this will result in slower buildup of equity.

Option #2: Refinancing to a shorter period as compared to your current mortgage.

You opt to refinance to a shorter period as compared to your current mortgage. For example, you have a 30-year mortgage, and you refinance to a 15-year mortgage.

Pros:

1. Pay off mortgage faster: You will finish paying off the mortgage quicker than the original schedule.

2. Less total interest: You will pay less total interest across the mortgage duration since the number of payments made are now lower.

3. Cheaper interest rate: You will likely pay less interest as the 15-year mortgage interest rates are usually lower than the 30-year mortgage interest rates.

4. Quicker equity build: You will build equity in your home much faster since you are paying more for principal each month.

Cons:

1. Increased monthly payment: Your monthly payment will likely increase when you shorten the mortgage term to a shorter duration.

Option 3: Refinancing to a longer term than your current mortgage

You opt to refinance to a longer period than the current mortgage. For example, you currently have a 15-year mortgage, and you refinance to a new 30-year mortgage.

Pros:

1. Lower monthly payments: You will have lower monthly payments since the principal is divided across a much longer period.

Cons:

1. Pay more total interest: You will be paying off more total interest over the life of the mortgage.

2. Longer time to pay off loan: You will take more time to pay off the loan since the loan period will be higher.

3. Higher interest rate: You will pay higher interest rate as 30-year mortgage rates are typically higher than 15-year mortgage rates.

4. Slower equity build: You will build equity in your home much slower since you are paying less each month.

Conclusion

Refinancing decisions are more complex than just looking at one component of the loan. All elements need to be considered in totality as well as their alignment (or misalignment) with your own personal goals. Longer or shorter mortgage terms each have their benefits as we covered above, and it really comes down to what makes sense for you in your situation. To make the best-informed decision, we recommend talking to a financial advisor who will have the latest and most accurate information.