You build home equity in two ways: first, by owning your home long enough to experience an appreciation in value, and second, by paying off your mortgage. You can't control your neighborhood's housing values, but you can accelerate your home loan repayment. The mortgage you choose affects the rate at which you amass home equity.
Current mortgage rates can help you pay your mortgage off faster if you choose to do so. Here are some scenarios to consider.
The 30-year rate and term refinance -- voluntary prepayment
Assuming you have a 30-year mortgage, this option allows you to refinance to an identical loan term at a lower mortgage rate and continue to make your old higher payment. You can put the difference toward building home equity and retiring your mortgage faster. Run some numbers through HSH.com's mortgage calculator and see how this works.
For example, if you have a 2-year-old $300,000 30-year mortgage at 4.5 percent, your payment is $1,520, your current balance is $290,098, and your loan will be paid off in 2039. If you refinanced that mortgage at 3 percent and continued to pay the same $1,520 per month, your mortgage would be retired in 2031 -- eight years earlier -- and you would save over $113,278 in interest (all without paying a penny more each month).
Since your required new payment would be lower ($1,223), we'd call this a "constant level payment" strategy of retiring your mortgage sooner. If you're comfortable handling your current monthly payment at your present interest rate, just keep sending that payment regardless of your new loan's rate. In the example above, that's the equivalent of sending in an extra $297 per month.
The shorter mortgage term -- forced prepayment
Another way to accelerate your mortgage payoff is to refinance to a shorter term. This confers a couple of advantages over a 30-year refinance. First, mortgages of 20, 15 or 10 years come with lower interest rates than 30-year loans. Second, it takes less discipline to save because the higher payment is mandatory -- not optional as it would be if you chose a 30-year mortgage and volunteered an extra principal payment each month. The downside is that, due to the shorter term, your monthly payment would be higher than if you took another 30-year term. If you choose a mortgage with a shorter term, it is advisable that you have emergency funds to cover at least six months of mortgage payments.
How much can you save by choosing a shorter term? According to HSH.com, current 15-year mortgage rates run about half a percent lower than 30-year rates. So, if instead of refinancing your 30-year loan to 3 percent, you could get 2.5 percent rate on a 15-year mortgage. Your new monthly payment on that $290,098 balance would be $1,934, $414 more a month that you are paying now (and $711 more than the required payment on a new 30-year loan). However, your loan would be retired in 2036, and compared to your original loan, you'd save over $162,500 in interest charges.
Related: In Praise of 15-year Mortgages
A shorter term may mean a sizable increase in monthly payment, and you'll need sufficient income to qualify for it. If you can't try the next available longest term; even with the same 3% rate as your potential 30-year refinance, choosing a 20-year term would only lift your payment from your existing loan by about $89 per month, but you would cut 8 years off your remaining loan term and save over $119,600 in interest costs, too. That's a pretty good return for just $89 per month.
One other consideration is to refinance to a new 30-year term and prepay your mortgage to be any term you like. Of course, you won't get the interest-rate break a shorter-term mortgage would bring, but you also aren't locked into the higher payment should you find yourself needing additional budget flexibility from time to time.
The adjustable-rate mortgage
What if you don't plan to stay in your current home for too much longer? Perhaps a change in your job, an increase or decrease in family size, increase in income, or retirement may be prompting you to move soon. If any of these events are in your foreseeable future, you may not need to commit to the higher payments of a 15-year mortgage to make a serious dent in your home loan balance.
Instead, consider a hybrid adjustable rate mortgage (ARM). These loans are amortized over 30 years, so your payment doesn't have to be huge, but their interest rates are often even lower than 15-year mortgages. Hybrid ARM interest rates are fixed for periods of 3, 5, 7 or 10 years, and then most adjust every year thereafter. The 5/1 hybrid ARM is the most popular, and rates on these loans are typically half a percent lower than those of 15-year mortgages. However, since most ARMs aren't sold to the secondary markets, there can be wide variability in rate from lender to lender, so you'll need to shop even harder to find the best deals if you are considering this option.
If you refinanced the $290,098 balance of your 4.5 percent 30-year mortgage to a 5/1 hybrid ARM at 2 percent, you could continue paying $1,520 each month, but in five years your mortgage balance would be down to just over $224,000. If you did not refinance it would be over $261,000!
Forced savings
Mortgage repayment is often referred to by financial planners as "forced savings." Home equity is an investment, and building home equity is building wealth. Unlike other forms of savings, mortgage payments are not optional, and spending home equity is a lot harder than emptying your savings account. For this reason, many financial advisers recommend building home equity and paying off your mortgage before retirement.
See HSH's Guide to Home Equity and Home Equity Calculator and Projector
Loss of liquidity
However, prepaying your mortgage does have a downside. Money invested in mutual funds is much easier to get at in case of emergency. Other investments may carry more risk but could provide greater returns over time than the guaranteed, fixed return if paying down your mortgage. Building equity is great, but equity isn't liquid, and to have access to those funds you'll need to pay interest to do so. Also, if you have a financial crisis, you may be unable to release your home equity by borrowing against it. Lenders are known for curtailing access to equity when market conditions turn less favorable for them. in addition, pushing your extra funds into your mortgage, you may not be making the best use of them. If, for example, you still have high-interest credit card debt, or your tax-deferred retirement accounts are not fully funded, channeling extra money into your mortgage may not be your best option.
Related: HSH.com's comprehensive Mortgage Prepayment Guide
Before refinancing to a shorter term loan or prepaying your mortgage, evaluate your finances. If your retirement is not topped up, or you owe high-interest debt, refinancing to a hybrid ARM or 30-year loan and using the savings to resolve these issues is a good idea. If your finances are well in hand, accelerating your mortgage payoff is a low-risk way to ensure a healthier financial future.
This article was updated and revised by Keith Gumbinger
