When Should you Refinance to Shorten the Loan Term?


If you had the opportunity to shorten the loan term of your mortgage, you would probably jump at the chance, right? What if someone told you that it might not be the right decision for you? Shocking, right? The truth is that it is not always the perfect answer, but it really depends on your financial situation as well as your life goals. What is right for you might not be right for your neighbor, so consider the following questions when determining if you should or should not shorten your loan term’s length.

What are your financial goals?

The first step is to figure out what your financial goals are in life. Here are a few things to consider:

  • Do you have kids? If so, do you have college funds set aside?
  • Do you have other debts that need to be paid off, such as credit card debts?
  • Do you have a sufficient amount of money in savings?
  • Is your retirement account plentiful?
  • Do you have life insurance?
  • Do you have other investments?

The answers to these questions will help you to determine if you are spreading your money equally amongst the many needs you have in life. It does not make sense to invest all of your income into your mortgage when you can have up to 30 years to pay it off. Remember, your house is not a liquid investment so having money invested in other areas can help you to diversify as well as have more liquid accounts.

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How long are you staying?

This is a very large consideration. Are you in your “forever home” or do you see yourself moving in a few years? If you are not sure or you know that you will be moving soon, refinancing does not make much sense. Sure, you will save on interest costs since the shorter term loans almost always have a significantly lower interest rate, but the cost of refinancing to shorten the loan term will offset those savings. If you are going to stay for 10 years or longer, it might be worth it; you have to do the math to see how long it would take you to recoup your closing costs to see if it makes sense.

Do you have extra disposable income?

Because the payment on a shorter term loan will be significantly higher than a longer term, you have to determine how much disposable income you have right now. As you look at that disposable income, or the money you have left after paying your bills each month, consider what you do with that money. Do you use it for daily living expenses or is it making its way into your savings account each month? It does not make sense to strap yourself for cash each month just to get your mortgage paid down faster because there are benefits to having a mortgage.

Do you need the tax write-off?

One of the largest benefits of having a mortgage for a longer period of time is the tax write-off you can utilize. The interest you pay is always tax deductible, which for some wage earners can really hurt them when they no longer have that deduction. If you have a large tax liability, it pays to determine what the difference will be without the interest payment tax deduction on your taxes before your refinance into a shorter term.

Do you qualify to shorten the loan term?

This is a question that requires careful consideration. Do you qualify for the shorter term? Just because you will pay the loan off faster and the interest rate is lower does not mean this loan is easy to qualify for. The largest hurdle is the debt-to-income ratio for most borrowers. Because the payment is much higher, you have the potential to have a much higher debt-to-income ratio that could make it impossible to qualify for the loan. If you have many debts aside from the mortgage, it might be hard to stay under the required 36% debt ratio.

As you can see, the determination between whether or not you should shorten the loan term of your mortgage really depends on your exact situation. If you do find that refinancing to shorten the term of your loan does not make sense, you can always pay extra money towards the longer term mortgage whenever you can, which will essentially lower the term without making it “official.”

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Justin McHood

Justin McHood is America's Mortgage Commentator and has been providing expert mortgage analysis for over 10 years.

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