Switching to a 15 Year Loan

Question: How do you determine if you should "exchange" your current 30-year loan for a 15 year loan?

Assuming you want to save money, the question is usually easily answered. 1) Multiply the monthly payment on your current, 30-year loan by the remaining number of payments. 2) Multiply the monthly payment of a potential 15-year loan by 180. Compare the two totals. The answer should jump out at you--especially if your 30-year loan is relatively new. A 30-year loan is usually far more expensive compared to a 15 year loan. I.e., you'll pay much more in interest with a 30-year loan compared to a 15 year loan. If your budget allows for the relatively higher payment of a 15-year loan, "exchange" your current loan for the 15 year loan.

How you exchange your 30-year loan for a 15-year loan is the next question. There are many different and valid ways of answering it. You could compare loans based upon total interest paid, before- or after-tax figures, Internal Rate of Return (IRR), Net Present Value (NPV), etc. Different methods evaluate to different numbers, but any valid method will identify your best choice.

The examples below are evaluated using the Net Present Value (NPV) method of investment analysis (for a different method of comparing loans, see Should I pay points or closing costs? NPV is employed for several reasons. The function is easily accessible via a financial calculator or spreadsheet program. NPV accounts for the time-value of money, investment risk, and requires relatively few calculations. Amortization and calculation of interest are not necessary. An NPV exists even when the IRR is undefined. When using NPV, be sure to compare investments with equal lives.

Simply put, the NPV is a measure of wealth. When selecting among several investments, the investment with the largest NPV should be chosen. In our examples, the NPVs are negative. You still select the loan program with the largest NPV--the one which is the least negative.

The first step in calculating NPV is to determine the amount and "direction" of the cash flows. In our examples, the loan amount is a positive cash flow--the borrower receives it. The payments are negative cash flows--the borrower pays them. To make our job easier, we'll use 15 annual cash flows, not 180 monthly cash flows. For the first cash flow--the loan amount--you must account for any loan fee you might pay. For example, if you get a $95,000 loan and pay a 1 percent loan fee ($950) from savings, your first cash flow is $95,000 – $950 = $94,050.

Hypothetical Example

Five years ago you obtained a $100,000, 30-year, fixed, 8 percent loan with monthly payments of $733.76. The balance on your loan is approximately $95,070--call it $95,000. If you keep this loan, you'll pay approximately $220,129 over the next 25 years (300 x $733.67). A quick look at a new, $95,000, 15-year loan at 7.375 percent shows total principal and interest payments for 15 years totaling approximately $157,308. The difference definitely jumps out at you and you don't need to go any farther to correctly understand that a 15-year loan is going to save you money. The next question is, what is the best 15 year loan to select?

Four options are considered. 1) Refinance your current, 30-year loan for a 15 year loan and pay the closing costs from savings, 2) Refinance your current loan for a 15-year loan and finance the closing costs by including them in your new loan, 3) Refinance your current loan for a 15-year, zero point loan, 4) begin paying your current, 30-year loan as it if were a 15 year loan (rarely will you incur any penalty for doing this, but check with your lender first). The least expensive choice is example one--the choice with the largest (least negative) NPV. The interest rates and fees used for the examples reflect the market differences between a 30-year and 15-year loan as of the date of this writing.

Eg. 1. New 15 yr. loan, 7.375%, borrower pays 1 point loan fee from savings.

CF 0: Borrower's initial cash flow = $95,000 – $950		$94,050.00
CF 1 - 15: Borrower's annual payment: ($873.93 x 12)		–$10,487.13
NPV		– $ 7,362

Eg. 2. New 15 yr. loan, 7.375%, borrower finances 1 point loan fee.

CF 0: Borrower's initial cash flow = $95,950 – $950		$95,000
CF 1 - 15: Borrower's annual payments: ($882.67 x 12)		–$10,592.00
NPV		– $ 7,427

Eg. 3. New 15 yr. loan, 8%, 1 point rebate pays loan fee. Increased interest rate required to obtain 1 point rebate.

CF 0: Borrower's initial cash flow = $95,000		$95,000
CF 1 - 15: Borrower's annual payments: ($907.87 x 12)		–$10,894.43
NPV		–$10,198

Eg. 4. Keep current, 8% loan, make payments based on 15 yr. amortization. (This is the same as eg. 3.)

CF 0: Borrower's initial cash flow = $95,000		$95,000
CF 1 - 15: Borrower's annual payments: ($907.87 x 12)		–$10,894.43
NPV		–$10,198