Refinancing to a short-term loan: Should you do it?

Homeowners are flocking to a refinancing option that could help them save money: shorter-term mortgages.

In fact, of the borrowers who refinanced during the fourth quarter of 2013, 39 percent shortened their loan term in order to take advantage of low interest rates, according to the 2013 Fourth Quarter Refinance Report released by Freddie Mac earlier this month.

The percentage was up 2 percent from the previous quarter and the highest since 1992, Freddie Mac reported. Why are homeowners suddenly rushing to shorten their mortgage terms?

Lower interest rates could be one reason. The Refinance Report noted that the average rate difference between a 30- and 15-year fixed-rate loan was .87 percent in 2013 - the largest difference ever recorded.

"Many borrowers have taken advantage of this difference to shorten their loan term," adds the Report. And lower interest rates mean bigger savings.

[Do you want to save on your mortgage? Click to compare interest rates from lenders now.]

However, while there's a big payoff for those who can refinance to a shorter loan, it isn't the right option for everyone. In fact, even though shorter loan terms typically have lower interest rates, they also yield higher monthly payments which may not be sustainable for some people.

Wondering if refinancing to a short-term loan is right for you? Here is some information to help you decide whether or not a shorter-term loan should be in your future.

Refinancing is Popular among Soon-to-be Retirees

"It's normally middle-aged baby boomers who have the income and they want to pay their mortgage off sooner before they retire," says Steven Lazerson, a senior loan officer with TLC Financial Services in Diamond Bar, California.

He adds that soon-to-be retirees are also in better financial positions to handle higher monthly payments.

"That's my favorite scenario for a 15-year mortgage," says James Adair, a loan originator with the Aspire Mortgage Group, based in Portland, Oregon."People in their early or mid-50s who see retirement as tangible in 15 years and want to have their mortgage paid off."

Adair says he's worked with clients in that demographic age range who stressed how important it was for them to retire without a mortgage.

"If you're heading into retirement on a fixed income, you don't want to have a $2,000 a month house payment," Adair says. "The way to engineer that is shortening the loan term and timing the last payment to the time of retirement."

[Are you ready to refinance your mortgage? Click to compare interest rates from lenders now.]

It's Harder to Qualify for a Shorter-Term Loan in 2014, but it's still Worth a Shot

Unfortunately, refinancing to a shorter-term loan isn't an easy process, especially with Dodd-Frank's new "Ability-to-Repay" rules now in effect.

As of January 10th 2014, lenders are prohibited from giving mortgages to borrowers who have debt that accumulates to more than 43 percent of their gross income. And since mortgage payments are included in your debt-to-income ratio, a shorter-term loan - which comes with higher monthly payments - may cause you to exceed the 43 percent threshold. As a result, qualifying for a shorter-term loan is tough.

But if your income is stable and you can afford the higher payments, refinancing to a shorter loan could be well worth it due the potential savings.

Here's an example: Matt Jolivette, owner of the Associated Mortgage Group in Portland, Oregon, says a 30-year fixed mortgage at 4.5 percent has a monthly payment of $1,266 per month, compared to a 15-year loan at 3.375 percent interest, which has a monthly payment of $1,771.

"That's a nice car payment difference," Jolivette says.

But the kicker is that for that "additional car payment," a borrower who can handle that amount will pay just $69,000 in interest during the 15-year loan. Over 30 years, interest costs jump to $206,000.

Shorter-Term Loans Could Limit Your Financial Flexibility

Refinancing to shorter loan terms have distinct advantages for people who want to build equity faster, but it's still a highly individualized decision.

In fact, even if you can afford the higher monthly payments that come with a shorter-term loan, you might prefer the financial flexibility that comes with the 30-year loan.

"The 30-year mortgage is a cash-flow tool," says Jolivette in reference to the lower monthly payments associated with long-term mortgages. The lower monthly payments allow homeowners to "afford other necessities in life," he adds.

What's more, if you don't want to be married to the higher payments associated with shorter loans, you can simply add more money to your monthly payments and achieve a similar result to refinancing. The only difference is you won't receive the lower interest rate that comes with shorter loans, but that's the trade off for financial elasticity.

The Bottom Line

"If you're not a disciplined saver, shorter terms could be like a forced savings opportunity to help you start paying down your loan faster," Jolivette says. "People are attracted to the shorter loans because more of their money is going directly into their property as opposed to right into the banks' pockets."

But again, it's not for everyone. So, conduct your research, talk to your lender, and evaluate whether or not refinancing to a shorter-term loan will actually be beneficial for you.

Watch the video below about why you should think about refinancing now: