- - Thursday, June 14, 2012

Q. My husband and I are jumping on the refinance bandwagon but can’t agree on what to do. We have a current loan balance of $286,000 at 4.75 percent. It is a 30-year fixed-rate loan, and we have 22 years left.

I would like to refinance to another 30-year term and lower the payment. My husband says we can get a better rate if we refinance to a 15-year program, but the payment will be higher.

We have good income and credit and our house is worth at least $500,000. Even though rates are higher with a 30-year program, I like the tax deduction. Which program is best for us: a 15-year or a 30-year?

A. Yours is a common question. Deciding on a loan term can be easy as long as the borrowers’ objectives are properly defined. In other words, there is no right or wrong answer, and your objectives can be determined by answering a few questions.

Let me first comment on your reference to liking the higher mortgage-interest tax deduction with the 30-year loan. Indeed, the higher the interest rate, the bigger the tax deduction. But just because a particular expense is tax deductible doesn’t make it financially advantageous enough to justify increasing the cost of the expense.

If, for example, the purchase of a loaf of bread was tax-deductible, the consumer would not be financially better off by purchasing a more expensive loaf if an identical loaf was being sold at a lower price.

Now let’s talk about the advantages and disadvantages of 15- and 30-year fixed-rate loans. The biggest advantage in taking out a 15-year loan instead of a 30-year loan is that the interest rate is lower.

You should be able to find a 15-year loan with little or no fees at about 3.25 percent. A 30-year loan will be closer to 3.75 percent. The difference of half a percentage point in simple interest on a loan amount of $286,000 is $119 per month.

The biggest disadvantage of a 15-year loan is that the promissory note requires that you pay off the loan in 15 years, making the required monthly payment higher. Your principal and interest (P&I) payment at 3.25 percent over 15 years would be $2,010 per month. The P&I on a 30-year loan at 3.75 percent would be $1,324 per month.

The pros and cons of a 30-year mortgage are the opposite of a 15-year loan: The rate is higher but the monthly payment is lower.

Here are the questions you and your husband need to answer to determine whether you should go for a 15- or 30-year term:

  • How important is payment flexibility? If you feel that you can afford the payment on a 15-year loan but are uneasy about being required to make the payment each month, the 30-year term might be better. You can always take the 30-year loan and pay it off over a 15-year term by making extra principal payments. If, in the future, you decide you want a lower monthly payment, you have the ability to lower it.
  • Are you a disciplined saver? Many homeowners choose a 15-year term because they are required to pay off the loan in 15 years. For those folks who do not have a good savings plan, a 15-year loan forces them to reduce their debt and build equity faster, which is the same as putting money into a savings account.
  • Is your overall financial picture well-balanced? If most of your wealth is the equity in your home and you have little or no other savings, a 30-year loan might be a better choice with the plan of taking the difference in monthly payment to build up a savings account.

These are the kinds of questions you need to ask yourself. The answers will determine the appropriate mortgage program.

Henry Savage is president of PMC Mortgage in Alexandria. Send email to henrysavage@pmcmortgage.com.

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