Shift to shorter loans is not for everyone

December 14, 2010 | Comments Off on Shift to shorter loans is not for everyone

With interest rates at record lows, 15-year mortgages are gaining popularity. But they have higher monthly payments than longer loans.

By Amy Hoak of MarketWatch

A shorter home loan isn't for everybody (© Jupiterimages/Comstock Images)Click to enlarge picture

More homeowners are choosing to pay down their mortgages faster — even if it means a substantial jump in their monthly payments.

From January to June, 26% of homeowners who refinanced chose a 15-year fixed-rate mortgage, according to data from CoreLogic, a provider of financial, property and consumer information. In 2009, 18.5% of borrowers who refinanced opted for a 15-year term. About 9.4% did so in 2007.

What’s prompting the shift to shorter loans? Historically low interest rates for fixed-rate mortgages.

Homeowners are doing the math and realizing that rates have decreased enough so paying more for a new 15-year mortgage, compared with their current loan, is bearable, says Bob Walters, chief economist at online lender Quicken Loans. 

The average rate on a 15-year fixed-rate mortgage was 3.62% for the week ending Oct. 14, according to Freddie Mac’s weekly survey of conforming mortgage rates.

A change in thinking
Homeowners who can refinance now typically have the best credit, have the most equity and are best-suited for a shorter-term loan.

But some psychology might be at work.

“We’re seeing a different view on debt than maybe we’ve seen in the past,” Walters says.

Homeowners are saying, “I really want to pay this off. I’m going to bite the bullet and take the payment and work toward paying this down.”

With the average rate on a 15-year fixed-rate mortgage at less than 4%, having a mortgage rate that starts with a three is attractive for people who can afford it, says Leif Thomsen, chief executive of Mortgage Master, a privately owned lender.

It also is kind of a forced savings account for homeowners, he says, given that the higher payments help pay down the principal quicker.

This is a huge shift in borrower thinking.

“There was a drive a couple of years ago to take out the biggest mortgage that you could and use all of the money you would have otherwise had in the house and put it into stocks and bonds — to think of your house and mortgage as part of your entire investment portfolio,” says Amy Crews Cutts, deputy chief economist for Freddie Mac.

“That worked for people who do investment finance for a living and are good at managing accounts,” she says. “But for average (people), debt is a drag on their psyche as well as their overall budget.”

Many Americans have reverted to the goal of paying off their house and getting rid of their mortgage, Cutts says.

Doing the math
Refinancing into a shorter mortgage isn’t a strategy for everyone, however.

Choosing a shorter term usually means that you’ll get a better rate and that you’ll pay much less interest over the life of the loan. But a shorter time frame ramps up monthly mortgage payments.

For example, with a 4.5% interest rate on a 30-year fixed-rate mortgage of $200,000, you would have a monthly payment of about $1,015, including principal and interest, Cutts says. The monthly payment jumps to about $1,480 with a 4% interest rate on a 15-year fixed-rate loan.

Of course, if your current 30-year loan has a higher rate, the difference between the monthly payments could be less. Still, you should count on some increase in monthly payments.

In general, Walters says, those who choose 15-year fixed-rate mortgages are older and have more equity and less debt than others. They also earn higher incomes and don’t have some of the added expenses that younger homeowners typically do.

“People who are taking these loans are financially stable and can afford the payments but at the same time are planning on staying in their home for an extended period of time,” Thomsen says.

Walters says homeowners shouldn’t take on a 15-year fixed-rate mortgage unless they have substantial savings, including at least a year’s worth of living expenses in liquid accounts.

He also recommends having a debt-to-income ratio of less than 35%. So if you have a gross income of $5,700 per month, for instance, your recurring monthly debt — including any mortgage payments, taxes, insurance, homeowners-association dues, auto and student loans, and credit-card debt — would have to be less than $1,995 to get a 35% ratio.

Make that extra payment
Borrowers who don’t meet those standards or who are worried about future income loss might be better served taking a longer-term mortgage and making extra payments to the principal to pay off the loan faster, Walters says.

For instance, if you refinance a $200,000 mortgage into a 30-year loan with a 4.5% rate and apply $100 of the savings to the principal payment each month, you’d save $31,700 in interest over the life of the loan, Cutts says. And you would pay off the mortgage in 25 years, instead of 30, she says.

What’s more, you would have the flexibility of not paying that $100 in months when money gets tight.

“Maybe today you’re feeling flush with money. Maybe you’re worried in the future that income might change,” Cutts says. With a 30-year mortgage, you have more flexibility. “Shortening to 15 years is a pretty big bump in payment.”



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