Refinancing to a shorter term can be a great way to give your equity building efforts a jolt. This is because a shorter term means that your interest is not stretched out over as many years, so you pay less of it. Additionally, even though the payments on the refinance loan may be higher than your original mortgage payments, more of the money goes to the principal. And this is how your home builds equity: by paying down the principal.

What is equity?

Your home builds equity as you pay down the principal, or as your home increases in value. Basically, equity is the difference between how much your home is worth and how much money you owe. For example, if you have a home that is worth $150,000, to figure out the equity, you subtract how much you still owe on your mortgage. If you still owe $90,000, the equity in your home amounts to $60,000.

Boosting your equity

Because so much of your mortgage payments go to interest during the first half of the term of your home loan, equity builds slowly, especially in the first 10 years. If you have an interest-only loan, the equity builds at an even slower rate. If you want to boost the rate at which your home builds equity, you can refinance to a loan with a shorter term. A shorter term means that you will have to make higher payments on the refinanced loan, but it also means that more of the money is going to the principal, helping you pay down the loan faster and building equity at a more rapid rate.

Advantages to refinancing to a shorter term

While the higher payments may be a deterrent to those whose income has remained steady for years, someone who has received an increase, and expects that increase to remain in place, can derive the following benefits from refinancing a mortgage to a shorter term, such as from a 30-year loan to a loan term of 10, 15, or 20 years:

Lower interest rate for a shorter term means you pay much less in interest

Shorter term means that the principal goes down faster, quickly building equity

Less money is paid out in interest on account of fewer years to spread the loan over

House is paid off faster, freeing the funds sooner than if you had a 30-year mortgage

Of course, before refinancing for any reason, you should make sure that your current mortgage is not subject to prepayment penalties.