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 6 percent, your payment is $1,799, your balance is $292,405, and your loan will be paid off by 2038. If you refinanced that mortgage at 4.5 percent and continued to pay $1,799 per month, your mortgage would be retired in 2031 -- seven years earlier -- and you would save over $80,000 in interest (all without paying a penny more each 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 will be higher. 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 4.5 percent, you could get 4 percent rate on a 15-year mortgage. Your new monthly payment on that $292,405 balance would be $2,163, $364 more a month. However, your loan would be retired in 2025, and you'd save over $100,000 in interest charges.
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 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.
If you refinanced the $292,405 balance of your 6 percent 30-year mortgage to a 5/1 hybrid ARM at 3.5 percent, you could continue paying $1,799 each month, but in five years your mortgage balance would be down to just over $230,000. If you did not refinance it would be over $262,000!
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.
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. If you have a financial crisis, you may be unable to release your home equity by borrowing against it. It's an unfortunate truth that it's hardest to borrow money when you need it most. Also, by forcing 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.
Before refinancing to prepay 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 healthy financial future.