4 steps to choosing the right refinancing term

Today's mortgage rates reflect a recent narrowing of the spread between 15-year and 30-year rates. For homeowners considering a refinance, that makes choosing between these terms a little bit tougher.

However, the best approach to this question remains to start from scratch, as if you were buying a home today.

Mortgage spreads get narrower

Thirty-year mortgage rates are generally higher than 15-year rates, resulting in a natural spread between the two. When 2014 began, the difference between 30-year and 15-year mortgage rates was close to a full percentage point. By early December though, it was down to 79 basis points.

This still makes 15-year mortgage rates cheaper, and of course, the shorter loan term means paying interest for fewer years. However, the big trade-off is that 30-year loans make monthly payments more affordable.

What makes this a particularly tough choice for homeowners looking to refinance is that their existing mortgages are often effectively somewhere in between. For example, someone eight years into a 30-year mortgage now has the equivalent of a 22-year loan. So, is it better for that person to refinance with a 15-year or a 30-year loan, and how do they compare either one with their existing loan since neither matches up with their 22-year remaining term?

Rather than using that existing mortgage as the starting point, it might be better to start as if you were a prospective home buyer choosing between a 15-year and 30-year mortgage. Once you decide which of these options is better, you can go back and do a reality check to see if it will save you money compared with your existing loan.

Starting over

Here is a step-by-step approach to making a fresh start in choosing a refinance mortgage:
  1. Use a mortgage monthly payment calculator to see what your remaining loan balance would look like in a 15-year and 30-year mortgage at current refinance rates.
  2. The monthly payments for the 15-year loan will almost certainly be higher than those for the 30-year loan, and may well be higher than your existing payments if you have considerably longer than 15 years to go on your mortgage. So, you need to check whether these payments would fit comfortably into your household budget.
  3. If you can afford the payments on a 15-year loan, assume this is better than refinancing to a 30-year loan because of the interest savings. If you can't afford the payments, assume a 30-year loan is the better option.
  4. The final step is to see if the option you chose represents a savings compared to your existing mortgage. Compare the interest expenses on amortization schedules for a refinanced loan and your existing mortgage to see which would cost you less in the long run.

This method assumes the primary refinancing goal is to lower long-term expense. If that's the case, the fresh start of deciding first between refinancing options -- and only then comparing with your existing mortgage -- may well clarify your decision.

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