The smartest way to save big on your mortgage

Anne Wynter
Is the length of your mortgage getting you down? Consider the benefits of refinancing to a shorter loan term.

Despite claims that slow and steady will win the race, we all know that if you're speedy, you'll have the best chance of crossing the finish line as the victor. And while paying off your mortgage isn't a competition, there are major advantages to getting a home loan that you can pay down faster.

Shorter-term home loans - such as 10-year, 15-year, and 20-year mortgages - typically come with lower interest rates and higher monthly payments. But before you decide shelling out additional money each month isn't doable, consider the benefits that could come along with paying even a little more each month.

So if you're thinking of refinancing so you can reach the proverbial finish line a little faster, keep reading to find out what you could stand to gain with a shorter loan term.

You Won't Lose as Much Money on Interest

One of the best arguments for refinancing and obtaining a shorter-term loan is that you can snag a lower interest rate - which means you'll pay significantly less interest over the lifetime of your loan. And if you're wondering why shorter mortgages come with lower rates, Fannie Mae's guide, "Taking the mystery out of your mortgage", notes that lenders consider shorter-term mortgages to be less risky.

So, just how big of a difference in rates are we talking about? According the "Primary Mortgage Market Survey" conducted by Freddie Mac, the average 15-year mortgage rate for 2012 was 2.93 - compared with a 3.66 average interest rate for a 30-year fixed-rate mortgage.

A lower interest rate, combined with a shorter loan term, is a combination that could save you a lot of money in interest. For example, let's use the average monthly interest rates for April 2013, according to Freddie Mac, to compare two mortgage term scenarios for a homeowner with a $250,000 loan.

Loan Type: 15-year fixed 30-year fixed
Total Loan Amount: $250,000 $250,000
Interest Rate: 2.66 percent 3.45 percent
Total Interest Paid: $53,456 $151,632

If you opt for the 15-year fixed rate mortgage in the example above, you will you finish paying off your mortgage more than a decade sooner, and you'll also spend $98,176 less in interest by the time you pay it off. Not too shabby.

Reap the Benefits When You Sell Your Home

And besides being the sole owner of your home, paying off your mortgage can also have a positive effect on your monthly cash flow. How? Consider the fact that, on average, housing costs amount to 33.8 percent of household annual expenditures, according to the U.S. Department of Labor. Eliminating your mortgage payment can cut out a significant chunk of that cost.

Plus, the Federal Deposit Insurance Corporation (FDIC) also points out that a homeowner who has paid off their mortgage will be in possession of a valuable asset - their home. This value can come in handy if you decide to sell your home or leave it to a family member, since you - or your family member - will profit from the sale, versus having to fork some of it over to the bank if you haven't paid it off yet.

Of course, don't forget that owning your home free and clear doesn't mean you won't have to pay anything else on it. Homeowners who have paid off their mortgage will still have to shell out money for insurance, real estate taxes, homeowner association fees, and the cost of any updates, notes the FDIC.

[Ready to refinance to a shorter-term mortgage? Click to compare rates from lenders now.]

Build Equity to Reverse an Underwater Mortgage

According to J.P. Morgan Chase & Co., approximately 7 million people were underwater on their mortgages in 2012. This essentially means that 7 million people owed more on their mortgage than the current value of their home.

Fortunately, some underwater homeowners are taking advantage of government programs and refinancing to shorter-term mortgages, which are helping them get their heads above water.

The Federal Housing Administration (FHA) offers two programs - the FHA short refinance and the Home Affordable Refinancing Program (HARP) - that can make it easier for homeowners to refinance and obtain more favorable loan terms.

In fact, the Federal Housing Finance Agency (FHFA) reports that an increasing number of people are using these programs to refinance to 15-year or 20-year mortgages that will help them regain equity more quickly and reverse their underwater mortgages sooner. They'll do this by making higher monthly payments, a majority of which will go towards paying the principal, rather than interest.

For example, let's say you took out a $200,000 loan in 2013. We'll compare the amount of interest and principal you'll pay by the year 2025 for both a 15-year and 30-year fixed-rate mortgage with a 4 percent interest rate. (Keep in mind that the interest rate for a 15-year mortgage is typically lower than that of a 30-year mortgage, but we'll keep it the same for the purpose of this comparison.)

  30-year FRM 15-year FRM
Year: 2025 2025
Monthly Payment: $954.83 $1,479.38
Interest Paid YTD: $5,845.78 $1,924.45
Principal Paid YTD: $5,612.19 $15,828.06
Balance: $143,086.05 $39,485.48

Based on this example, if you decide to take out a 30-year mortgage, you'll only have 28 percent equity in your home in 12 years. But, if you had a 15-year mortgage, you would own a whopping 80 percent of your home instead.