If you’re looking purchase a new home or refinance an existing one, it’s important to understand the basics of qualifying for a mortgage so you can get the best deal possible. It’s not as easy to get a mortgage these days as it used to be, so it’s important to understand the basics of qualifying and take some simple steps ahead of time to “groom” your financial profile. The idea is to position yourself ahead of time to get the best deal you can.

Mortgage lenders look at a variety of factors when making a lending decision, but most can be classified into three general categories, credit, capacity, and collateral – or the “3 Cs”.

Credit – Do you faithfully repay your debts?

Your credit scores are an important factor in mortgage qualifying because they indicate how well you manage debt. Mortgage lenders require a credit report from the three major credit bureaus (Equifax, Experian, and TransUnion) to document your payment histories for mortgages, auto loans, personal loans, credit cards, and any derogatory information such as collections, foreclosures, judgments, charge offs, bankruptcies, liens, etc. Credit scores are considered highly predictive of the risk of lending to you, so lenders give them a lot of weight. The higher your credit scores, the better!

Credit scores range from 300 to 850, with most people falling in the mid 600s and above. Scores below 620 are considered bad and scores above 720 are considered good. Ideally, you want to have all three of your credit scores in the mid 700s or better to get the best mortgage deals.

The following are some of the factors that weigh heavily on your credit scores:

• Debt payment history – Late payments, particularly on mortgages, can have a big negative impact on your credit scores. Be sure to make all your payments on time.
• Credit utilization – If you carry credit card balances that are more than 30% to 50% of your credit limit, it can have a big negative impact on your scores even if you’re making your payments on time. Over utilizing your credit can make you look “maxed out” and is considered a risk factor, which is why your credit scores are downgraded accordingly.
• Collections or charge offs – Past debts reporting as collections or charge offs can damage your credit scores significantly. If you have some of these in your credit file, be sure to get them resolved as soon as possible. If the debt is with a collection agency, you may be able to negotiate a reduced payoff, but be sure to get the agreement in writing.
• Bankruptcies and foreclosures – If you’ve had a bankruptcy or foreclosure in the recent past, pretty much the only cure for your credit scores will be time. Fannie Mae and FHA also have waiting periods of 2 to 4 years before you will be able to qualify for new mortgage financing.

Capacity – Do you have the financial ability to repay the loan?

Capacity has to do with your financial ability to repay the home loan. W2 income (you work for somebody) is considered the most stable income because it doesn’t typically vary much from month to month. Self-employed income is considered riskier from a lending standpoint because it can vary widely from month to month and the self-employed borrower is responsible for generating the business that creates the income.

If you’re a wage earner, the lender will typically want you to document your income with W2s, paystubs, and tax returns.  If you’re self-employed, you typically won’t have W2s, so you’ll be required to document your income with tax returns.

An important component of capacity is your debt-to-income ratio, or DTI. Your DTI is important because it shows what proportion of your income is dedicated to debt payoff. The higher your DTI, the tighter your finances are and the riskier it is for the lender to give you a loan.

Depending on the loan program, a mortgage underwriter typically won’t want to see a DTI higher than 45% to 50%. In other words, no more than 45% to 50% of your qualifying income should be going to debt service for mortgages, auto loans, credit cards, installment loans, etc.

Collateral – What is the security for the loan?

Because the property you’re financing will serve as collateral for the mortgage, the lender will be concerned with the value, type, quality, and condition of the property.

The value of your property is one of the most important factors because it allows the lender measure risk with a ratio called loan-to-value, or LTV.  LTV is essentially the percentage of the value of the property that you are borrowing. For instance, if your property is worth $100,000 and you are borrowing $80,000, the loan-to-value is 80%.

Lower LTV loans are less risky than higher LTV loans because the lender isn’t as likely to incur a loss in the event the borrower stops making payments. It’s because of this that lower LTV loans typically have better pricing and lower interest rates.

Most of the time you’ll be required to get a full appraisal to verify the value and condition of your property, but there are some refinance scenarios where a limited appraisal or no appraisal at all is needed.

Steps to Take Before Applying for a Mortgage

1) Check your credit. If you plan to purchase or refinance in the near future, it’s important to first check your credit to make sure there aren’t any issues that need to be cleared up ahead of time. Again, credit scores are an important factor when you finance a home, so you want to make sure they are as high as possible so you can get the best financing deal possible.

2) Pay off outstanding debt. If you have a lot of debt, I highly recommend paying off as much as you can before you apply for a home loan. Doing so will lower your debt-to-income ratio, make qualifying easier, possibly raise your credit score, and maybe result in better financing terms. Having a lower debt-to-income ratio could also position you to take advantage of shorter-term loan programs that offer lower interest rates and faster payoffs – which can put a lot of money back into your pocket over the life of the loan.

3) Take care of any needed repairs. If you’re refinancing, it’s important that your home appraise for as high as possible. If your home has some minor cosmetic issues or repairs that need to be done, take care of them before the appraiser comes out. Having your home in good condition could help you get a higher appraised value, which could result in better financing terms.

Preparing for Your Next Mortgage Is Well Worth the Effort

Unless you know you have a pristine financial profile, low debt, and high credit scores, I highly recommend doing some legwork ahead of time to make sure you put your best foot forward for your next mortgage loan. It’s common in the mortgage industry for borrowers to get surprised with unexpected hang ups such as derogatory credit items or unexpectedly low credit scores. Understanding how lenders think and preparing your financial profile before you start applying for loans can help you get a much better deal and make the loan process go much smoother.

FHA-insured mortgages are about to get more expensive.

Starting in April, the Federal Housing Administration is increasing the upfront and annual mortgage insurance premiums for FHA-insured loans. From a recent FHA press release:

As part of ongoing efforts to encourage the return of private capital in the residential mortgage market and strengthen the Federal Housing Administration’s (FHA) Mutual Mortgage Insurance Fund, Acting FHA Commissioner Carol Galante today announced a new premium structure for FHA-insured single family mortgage loans.  FHA will increase its annual mortgage insurance premium (MIP) by 0.10 percent for loans under $625,500 and by 0.35 percent for loans above that amount.  Upfront premiums (UFMIP) will also increase by 0.75 percent.

In case you’re not familiar with FHA financing, two types of mortgage insurance are required on the majority of FHA-insured loans:

1. Upfront mortgage insurance, or UFMIP, which is paid once at loan closing. FHA allows this premium to be financed into the loan.
2. Mortgage insurance premium, or MIP, which is paid in equal installments are part of your mortgage payment.

To see how the rate changes will impact the cost of an FHA loan, let’s assume a home buyer is putting down 3.5% on a new home and taking out a $200,000 FHA-insured loan.  The UFMIP premium will increase from the current rate of 1% of the loan amount, or $2,000, to 1.75% of the loan amount, or $3,500. The MIP will increase from 1.15% of the loan amount to 1.25%, which increases the monthly MIP payment from $191.66 to $208.66.

If you’re in the market to get an FHA loan, I highly recommend getting the ball rolling as soon as possible. You don’t need to have your loan closed before April to take advantage of the current mortgage insurance rates, your lender just needs to have your FHA case number before April 9, when the first premium change takes effect. If you don’t know what an FHA case number is, don’t worry about it, just make sure your lender has it before April 9.

Mortgage lending underwriting criteria falls into three general categories, credit, collateral, and capacity. Credit has to do with how well you pay your bills (as evidenced by a credit report and score), collateral has to do with the type and quality of the property you’re using to secure the loan, and capacity has to do with your financial ability to repay the loan. Your debt-to-income ratio falls into the latter category – capacity – and is considered an important factor in determining your financial ability to pay back your mortgage.

What is a Debt-to-Income Ratio?

Your debt-to-income ratio, or DTI, expresses in percentage form how much of your gross monthly income is spent on servicing liabilities such as auto loans, credit cards, mortgage payments (including homeowners insurance, property taxes, mortgage insurance, and HOA fees), rent, credit lines, etc.

Living expenses such as cable, gas, electricity, groceries, etc., are not considered part of your DTI.

If your DTI is high, it means you are highly leveraged and have tight finances, which, naturally, is considered risky from a lending standpoint. On the other hand, if your DTI is low, the lender knows you have plenty of room in your monthly budget to absorb unexpected expenses and still make your mortgage payments.

In today’s mortgage marketplace, the maximum DTI allowed is 45% for Fannie Mae loans and 50% for FHA-insured loans. In other words, for a Fannie Mae loan, no more than 45% of your gross (pre-tax) monthly income can go to debt service and mortgage and housing-related expenses.

Both Fannie and FHA allow for higher DTIs under limited circumstances, but these are the standard guidelines.

Calculating Your Debt-to-Income Ratio

If you’re in the market for a home loan, it doesn’t hurt to calculate your debt-to-income ratio ahead of time so you know where you stand. To do this, simply tally up your total monthly debt obligations and divide by your gross monthly income, as follows:

1. Either obtain a recent copy of your credit report or gather up your most recent statements for all your debt obligations. Note that only debt obligations are included in your DTI, not utility bills, phone, cable, etc.
2. Tally up your payments for all debts, including auto loans, credit cards (use just the minimum payment), credit lines, student loans, and any other debt obligations that you have.  If you have an American Express credit card, use 5% of the outstanding balance if the minimum payment is showing as the full balance on your credit report. Note that underwriters will include any child support payments in your DTI.
3. Add your rent or home mortgage payment, including monthly property taxes, homeowner’s insurance, homeowner’s association (HOA) fees, and private mortgage insurance (PMI) premiums.
4. Divide your total debt obligation figure by your gross monthly income (assuming you’re a W2 wage earner), then multiply by 100 to get a percentage.

If you’re self-employed, I recommend working with your loan agent to determine your qualifying DTI. Self-employed income verification is more complicated and there’s really no way to determine your qualifying income definitively without tax returns.

Keep in mind that when you’re qualifying for a home loan, your qualifying DTI will be based on what your expenses will be after the loan is complete. In other words, if you’re currently renting and are taking on a house payment higher than what you’re paying for rent, your qualifying DTI will be based on the new mortgage payment. If you’re refinancing and consolidating debts, your qualifying DTI will reflect your expenses after the various debts are consolidated.

Are you considering refinancing to consolidate multiple mortgages? With rates so low today, this can be a great way to reduce monthly payments and interest costs over the life of your loan, but unfortunately, it’s not always easy to accomplish. If consolidating mortgages is either not practical or simply impossible, there may still be some good loan options for you.

It’s no secret that lending guidelines are far tighter today than they used to be, so depending on what kind of second mortgage you have, when you took it out, and the total combined amount you owe on your mortgages, it may not be as easy to consolidate today into one loan as it was in past years.

The following are some common scenarios where consolidating multiple mortgages is either impossible or provides little benefit:

• You have a very low rate on your second mortgage. If you already have a low interest rate on your second mortgage (HELOCs often have very low rates today), it may not make sense to refinance and combine it with your first mortgage.
• Cash out refinance limitations. If you have a HELOC that you took out after you got your first mortgage, consolidating both loans may be considered “cash out” financing and subject to cash out loan-to-value limitations. Most banks tend to limit cash out loans to around 80% of the value of the home (lower if you have a “high balance” loan greater than the $417,00 conforming limit for most areas), so if you owe more than 80% between your mortgages, consolidating may not be an option at all unless you’re willing to pay down your loan balance.
• You will soon pay off your second mortgage. If your plan is to pay off your second mortgage in the next few years, it may not make sense to stretch it out again by consolidating into a new first mortgage unless you really need the lower payment.
• PMI may wipe out all the benefit in the new loan. If the total combined loan amount is greater than 80% of the value of your house, you’re going to end up paying a monthly mortgage insurance (PMI) premium. Unless consolidating results in a significant drop in your payment, the PMI may wipe the benefit in the new loan.

If your plan was to consolidate your mortgages but there’s no benefit in it or it’s impossible to do because of lending guidelines, ask your lender about redoing just your first mortgage and leaving your second mortgage intact in a subordination transaction. This is not as simple as a refinance transaction not involving a subordination, it may still provide you with benefit.

The following are some important considerations when evaluating loan options involving a subordination:

• The process is typically longer than a refinance not involving a subordination. Subordinations must be authorized by your second lien holder and can often take 2 to 6 weeks (sometimes more) to process.
• You’ll likely be charged a processing fee. Depending on who your second mortgage holder is, you’ll likely be charged $30 to $300 as a processing fee. Note that this fee is not being charged by the bank you’re refinancing with, but your second mortgage holder.
• You may not be able to lock your rate right away. As I mentioned, the processing of the subordination request can take some time, so don’t be surprised if you can’t lock your rate right away. Rate locks are usually done for 30 to 45 days, and if the subordination takes longer than that, you could end up paying relock fees.

Even with the above considerations, a subordination could be a very beneficial loan option. I’ve worked with clients who were able to consolidate, but a subordination option ended up saving them significantly more money on a monthly basis and over the long term.

If you’re considering consolidating mortgages, you might ask your consultant to run some subordination options as well to see if it can benefit you more.

If you’ve applied for a home loan recently, you’ve probably already figured out that the mortgage industry is a lot more nitpicky then it used to be. Five years ago lending standards were super loose, now they’ve swung to the opposite extreme and are overly tight in many circumstances.  It’s just not as easy to get a loan these days as it was a few years ago; not only are qualifications tougher, but the hoops you need to jump through to get the loan done have multiplied.

If you’re applying for a home loan where you need to come in with cash-to-close (as with a home purchase or refinance transaction where you’re paying down your loan at closing), plan on being asked to “source” and “season” the funds you’ll need to close.  I highly recommend planning ahead for this because it can be a real headache to take care of at the last minute.

Sourcing and Seasoning Cash-to-Close Funds

The first requirement for cash-to-close is that the funds be “seasoned” for at least 60 days. In other words, the lender wants to make sure you aren’t obtaining cash from somewhere on a short-term basis simply to meet the cash-to-close requirements of the loan.  To verify that you have “seasoned” funds, you’ll be asked to provide bank statements covering the last 60 days for all accounts you intend to use for your cash-to-close.

If you’re pulling cash out of an account that has some restrictions on withdrawals (such as 401ks, IRAs, etc.), you may be asked to provide the terms of withdrawal in writing as well.

One of the headaches that arises from bank statements is that the underwriter will likely require you to “source” any unidentified large deposits. Underwriters are concerned about such deposits because they want to make sure you aren’t pulling cash out of an unknown debt account that isn’t included in your debt-to-income ratio. Be prepared to provide cancelled checks or bank statements sourcing the deposits. If the deposits are transfers from another bank account, be prepared to provide the last two months of statements for that account and source any unidentified large deposits on those statements as well.

A Little Planning Ahead Can Help Simplify the Sourcing and Seasoning Process

Unexpected things often come up in the loan process, including low appraisals, property taxes coming due, etc., so it’s not always possible to anticipate cash-to-close issues ahead of time. However, if you’re going to be purchasing a home or refinancing and paying down the loan balance as part of the transaction, a little planning ahead can make the sourcing and seasoning part of your transaction much easier.

If you’re going to be coming in with cash at closing (purchasers, heads up!), I highly recommend pulling together the bank statements and sourcing documentation ahead of time so you’re not scrambling at the last minute before closing. Your loan consultant can help you determine what documentation is needed if you’re not sure.

If you’re still a few months from seeking mortgage financing, I highly recommend transferring the funds you’ll need to close a few months in advance into a single account that doesn’t have much deposit activity. This will help you cover the seasoning requirements as well as avoid sourcing headaches.

Lower Conforming Loan Limits to Stand For Now

Real estate industry groups have engaged in a flurry of last minute efforts to get Congress to postpone the conforming loan limit reduction set to take effect on October 1. Despite their efforts, it appears the new lower limits will stand – at least for now. Several efforts in Congress to extend the current limits have gone nowhere, but it’s an issue that could be revisited later this year according to the Orange County Register.

The conforming loan limit is the maximum loan amount that can be purchased by Fannie Mae and Freddie Mac. After the financial crisis of 2008, Congress increased the conforming loan limit to $729,750 for single-family homes (in the contiguous states, Puerto Rico, and DC) to support the housing market by allowing a greater number of mortgage borrowers in expensive markets to take advantage of low conforming rates. Now that the limit is set to be reduced to $625,500 on October 1, more mortgage borrowers will be forced to seek jumbo financing – which is typically more expensive and difficult to qualify for.

Naturally, realtors are concerned that this change will have a negative impact on the higher end of the housing market. It’s common for jumbo mortgage rates to run 1% or more higher than the rates on a comparable conforming loan product. If it’s tougher and more expensive to seek financing for higher-end properties, it makes sense that prices at the high end of the market may have to come down a bit to compensate. Whether or not that happens remains to be seen.

HUD Clarifies Annual MI Requirements for 15-Year FHA Loans

HUD clarified this week that the annual mortgage insurance premium required on FHA loans  (paid as part of the mortgage payment in 12 monthly installments) will not apply to 15-year fixed loans with loan-to-values of 78% or less.  The premium will still apply to 30-year loans regardless of loan-to-value.

HUD raised the annual MI premiums for FHA loans earlier this year to help compensate for loan losses due to the tough real estate market. Fortunately for new FHA borrowers, lower mortgage rates have somewhat offset the payment increase from the MI change. Unfortunately for existing FHA borrowers, the change has eliminated any payment benefit resulting from a refinance into today’s lower rates.

It’s no secret that your credit report and FICO scores play a big part when it comes to qualifying for a mortgage loan. Your credit scores, payment histories, and amount of outstanding credit give lenders insight into how well you manage your finances, how extended you are financially, and how much risk there is to lend to you.

The following are some important “dos” and “don’ts” related to credit reports to help you get the best possible on your next home loan.

Don’t let people run your credit report during the loan process. Lenders sometimes need to pull an updated credit report near the end of the loan process. If you’ve numerous inquiries since the initial credit report was run by your lender, it could pull down your scores and result in less favorable loan terms or loan denial. When you’re in the process of getting a new mortgage, don’t allow anybody to run your credit.

Don’t take on new debts. Lenders often will have you sign a document attesting that you haven’t acquired any new debts during the process of getting the new mortgage. If they discover that you have, they’ll include it in your debt-to-income ratio (DTI). If your DTI was already close to the maximum allowed by the lending guidelines, the added debt could result in a loan denial.

Don’t cosign for anybody. If the lender discovers a newly cosigned debt, they’ll include it in your debt-to-income ratio even if somebody else is going to be making the payments. If your DTI is tight already, this new debt could result in loan denial.

If you plan to cosign for somebody, make sure to do it after your new loan is funded.

Do continue to make all payments on time. Make sure to continue to make all debt payments (including your mortgage) on time as you move through the loan process. As I mentioned before, lenders often will update your credit report and/or mortgage rating near the end of the loan process, and if you’ve missed a payment on anything, it could jeopardize the loan.

Do unlock any credit report freezes before beginning the loan process. Credit freezes can take some time to clear, so if you have them on your credit report, make sure to remove them from your report for all three of the major credit bureaus (TransUnion, Equifax, and Experian) ahead of time.

If you begin the loan process before clearing the freezes, it can delay the processing of your loan and cause you to incur additional fees for rate lock extensions.

Do remove any consumer statements that could cause the lender to question your qualifications.  People often add consumer statements to their credit reports to dispute the reported information. If you’ve added a consumer statement to your credit report, I recommend getting it removed – particularly if it’s related to your mortgage – before you begin the loan process. If an underwriter sees it, they may request additional information and/or documentation that otherwise could have been avoided.

Consumer statements can take some time to remove, so it’s best to do it well in advance of applying for the loan.

Do clear up any derogatory credit items before beginning the loan process. Derogatory items such as collections, judgments, and charge-offs can negatively impact your credit scores and prevent you from getting the best deal possible – or getting a loan at all.

Before you begin shopping for a loan, make sure to pull a copy of your credit report from all three credit bureaus (TransUnion, Equifax, and Experian) and clear up any derogatory items reported. Yes, it can be hassle to do this, but it could save you thousands of dollars in interest over the life of your new home loan or make the difference between qualifying and getting denied.

Do make sure home equity lines-of-credit are reporting as mortgages. I often see home equity lines (HELOCs) reported as revolving accounts (like credit cards) instead of mortgages on credit reports. If your HELOC is being reported as a revolving account and the balance is over 50% of the available limit, your credit scores could take a hit.

The credit bureaus rate your scores down if you have balances on revolving accounts over 50% of the limit because you appear to be “maxed out”.  If your HELOC is reporting as a revolving account (often designated with an “R” on the credit report), be sure to call your lender ahead of time and get it corrected.

Mortgage groups and a bipartisan coalition of lawmakers are making a last-minute push to extend conforming loan limits before they expire at month’s end.

More than a dozen industry groups sent a joint letter this week to the Senate leaders sponsoring a bill that would keep the higher limits in place through 2013.  In it, the trade organizations pledged to work with lawmakers but warned that time was short — and that the stakes remain high.

“Any further disruption to the real estate market will stall our recovery,” the letter reads in part. “Extending the existing limits at levels appropriate for all parts of the country will provide homeowners and home buyers with safe, affordable financing and help stabilize local housing markets.”

The bill, the Homeownership Affordability Act of 2011, is sponsored by Sens. Robert Menendez (D-NJ) and Johnny Isakson (R-GA) and co-sponsored by Sen. Diane Feinstein (D-CA).

Earlier this year, the Treasury Department recommended Congress allow the loan limits to return to pre-2008 levels. That year, Congress voted to boost limits to spur economic growth. Without action, the current $729,750 cap would return to $625,000 effective Oct. 1.

Some Congressional lawmakers are also pushing for an extension as the clock runs down. A group of 37 sent a letter to the House Appropriations committee on Thursday advocating for a short-term extension.

At this point, the most likely path for any loan limit extension is through a provision attached to a must-pass government spending bill, lawmakers told MarketWatch.

Thanks to an uncertain economy and job market, many people are opting to start their own businesses to help make ends meet. If you’ve recently moved from W2 status to self-employed and are planning to take advantage of today’s low mortgage interest rates, its important to understand some of the lending guidelines that may apply to your situation. 

Today’s mortgage lending marketplace is dominated by Fannie Mae and FHA-insured financing, and both will have roughly the same self-employment qualification requirements.  First, underwriters will want to see that you have at least a two-year history in the same line of work. It’s not typically a problem if you’ve changed from a W2 job into your own business during the last two years as long as you’ve stayed in the same or a closely related field. If you leave a W2 job and start a business in a completely unrelated field, you’ll likely need to wait until you’ve had your business for at least two years before you’ll be able to use your self-employment income to qualify. 

If you’ve started a side business to supplement your existing W2 income – even if it’s in the same line of work as your job – you won’t be able to use the income to qualify until you’ve had the business for at least two years. Again, underwriters want to see a two-year track record of earning the income before they’ll allow you to use it to qualify.

The second part of the equation is verifying income. Back in the glory days of the housing boom, self-employed borrowers could take advantage of stated income programs that did not require income verification. However, things aren’t so easy anymore thanks to a much tighter lending climate. Stated income programs are all but impossible to find these days, so self-employed borrowers should expect to be asked for full corporate and personal tax returns (where applicable) – which means you’ll need to have been in business for at least a full tax year. 

The income used to qualify will be the net income after all deductions, not the pretax figure. Underwriters can often add back some deductions (such as depreciation, depletion, and some other expenses), but if you write off a lot on your taxes, it could be difficult to qualify. 

Qualifying with self-employment income is not as easy these days as it was a few years ago, but it you have good credit, equity in your home, and can show enough net income on your tax returns, you should be able to take advantage of today’s low rates. Hopefully as the credit crisis eases and the housing market stabilizes, self-employment qualifying guidelines will ease up as well.

Mortgage interest rates have dropped significantly over the past few years and many homeowners and investors are taking advantage of them to save money on payments and interest. If you’re in the market to refinance for a lower rate, I encourage you to consider shortening your loan term as well. You won’t necessarily end up with a lower monthly payment (it might even be a little higher), but you’ll pay off your home off faster and save a ton of interest over the life of the loan.

To demonstrate the incredible wealth preserving power of a shorter loan term, let’s take a look at a loan scenario that’s based on the actual situation of one of my past clients. Let’s assume our hypothetical borrower currently has a 20-year fixed loan at 7.75% that he’s been paying on for 4 years and wants to refi for a lower rate and shorter loan term. The following are his refinance options, which assume the lender covers all 3rd party closing costs and the new escrow deposits will be rolled into the loan:

Notice that as the loan term decreases from 20 years to 10 years the interest rate decreases as well. Loans with faster payoffs carry less risk, so lenders are willing to offer lower rates for shorter term loans. For instance, a 15-year fixed loan often prices out 0.5% lower than a comparable 30-year fixed loan and a 10-year fixed loan often prices out another 0.125% to 0.25% lower than the 15-year fixed loan. The popular 30-year fixed loan generally carries the highest rate of all fixed loans because the lender shields you from interest rate risk for an entire 30 years. A lot can change in the world over 30 years, so the lender wants to be compensated for protecting you from long-term interest rate risk.

Another great benefit of a shorter-term loan, in addition to the lower rate, is that you’ll build equity much faster. Growing your home equity grows your net worth, so you can look at your equity like a savings account that grows as your property appreciates and your loan balance decreases.

Check out the chart below, which shows the principal and interest breakdown for our borrower’s current loan and the loan options he is exploring. Notice how much more of the payment goes to principal as you go from left to right in the chart. The first payment for the new 20-year option only contributes $318 toward equity while the 10-year option contributes $890!

The combination of the shorter term and rate discounts you get with a 20-, 15-, or 10-year loan over a 30-year loan results in a ton of interest saved over the life of the loan. Plus, you get your house paid off a lot faster too!  To me, a dollar saved is a dollar earned; the interest you save on your mortgage is wealth that remains in your pocket instead of going to your mortgage lender. 

Check out the chart below, which shows the total accrued interest over the life of the various loan options our borrower is exploring.

If our borrower opts for the 15-year loan, he’ll save over $45,ooo in interest versus continuing to pay on his existing 20-year fixed. If he opts for the 10-year, he’ll save over $67,000 versus his current loan. Sure, the payment for the 10-year option is nearly $200/month higher than his current payment, but unless he is super tight financially, there’s probably some other areas in his budget where he can trim back.

If you’re in the market to take advantage of today’s low rates and refinance an existing loan, consider taking out a shorter-term loan, such as a 15-year or 10-year fixed. Yes, the payment is higher than a 30-year fixed loan, but consider it an investment in your net worth.  You’ll put tens (or even hundreds!) of thousands of dollars back into your pocket instead of sending it to you lender. Consider cutting out some unnecessary expenses to make up for the increased house payment. Believe me, your net worth will thank you!