Mortgage Rate or Loan Term - Which is More Important in a Refinance?

Historically low mortgage rates combined with record unemployment have led to a surge of refinances as homeowners look for ways to keep their homes affordable. If you are considering refinancing your home mortgage, finding the lowest interest rate is only part of the story. The term of your new mortgage will affect not only your monthly payment but the total cost of your loan.

Know why you want to refinance

 Homeowners often consider refinancing when interest rates are low, when they have significant equity in their property or when they need to revamp the household budget. For many homeowners, the main reason to refinance is for a lower monthly payment. Monthly payments can be lowered by reducing your interest rate or lengthening your loan term.

If you can handle a larger payment, you can save thousands of dollars of interest by shortening your loan term or switching from an adjustable-rate mortgage to a fixed-rate mortgage. Clearly understanding your motivation to refinance a home loan will help determine which mortgage refinance option is right for you.  

Know your current home loan

When gathering refinancing information, you should be sure you know the rate and the term of your current home loan. The rate is the percentage of interest you pay on the loan per year, while the term is the length of time avaiilable to pay off the loan.

There are two key elements to arranging financing for a home. First, you must choose a loan amount and a monthly payment that you can comfortably afford. Second, you need the loan to fit in with your entire financial plan. For example, if you intend to retire in ten years, you should consider whether you want to have a mortgage payment in retirement and, if so, what the maximum monthly payment should be.

Choosing the best term for your refinance

If you're like most people, the best of all worlds is a mortgage with the lowest possible interest payments and the shortest term so that you can own your home free and clear as soon as possible. But not everyone can afford a short-term loan, so most homeowners will need to compromise a little bit on the length of their loan in order to keep their monthly payments in a comfortable range when refinancing.

In September 2010, at a time when mortgage interest rates were below 5 percent for 30-year fixed-rate loans and sometimes below 4 percent for 15-year fixed-rate loans, many homeowners opted to shorten their loan term by refinancing into a 15-year loan. While their monthly payments typically rose a little (depending on their previous home loan rate and terms), these homeowners will have paid significantly less interest over the life of their loan by refinancing.

Refinancing scenarios

While it would be nice to pay off your mortgage loan as soon as possible, the monthly payments have to fit into your budget or you're setting yourself up for financial trouble later. Consider the following potential mortgage rate and term scenarios:

Scenario 1: A homeowner refinancing a $200,000 home loan is offered a 30-year, fixed-rate home loan at 5.0 percent, with monthly payments of $1,529.

Scenario 2: An alternative for this homeowner is a 15-year, fixed-rate loan at 4.5 percent interest, with a monthly payment of $1,529.

Scenario 3: Another option is a 10-year, fixed-rate loan at 4.0 percent interest, with a monthly payment of $2,024.

Scenario 4: A fourth choice for this homeowner is to refinance into a 40-year, fixed-rate loan at 6.0 percent interest, with a monthly payment of $1,100.

This hypothetical homeowner would need to evaluate his or her goals for the mortgage refinance and the monthly payments associated with each term. While the payments for the 40-year loan are significantly lower, the interest paid over the life of the loan will be much higher. If the homeowner's goal is to pay off the loan within the shortest time or to pay the least amount of interest, then the 10-year home loan offers the best option.

Additional home loan payments can always be made to decrease the principal each year, so even after homeowners decide which home loan rate and terms suits their refinancing needs best, they can continue to make personal budget adjustments to pay off their mortgage faster.

Clearly, both the rate and the term must be considered together when evaluating a home refinance.




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