With current mortgage rates as low as they were during the Great Depression, homeowners are refinancing to shorten their loan term from 30- to 15-year fixed rate mortgages (FRMs). Since interest rates are so low, homeowners can shorten their loan term substantially and pay a mere $300 to $500 more a month.

One in four homeowners refinanced into a 15-year fixed rate mortgage in the first half of 2010. This was a notable increase from 2007, when approximately one in ten homeowners refinanced to a 15-year FRM.

Of course, most homeowners currently do not qualify for a refi. The majority of homeowners who are taking advantage of low interest rates on 15-year FRMs are settled in their homes with a dependable and substantial income stream. In other words, the recent trend in 15-year refis does not apply to the millions of distressed and underwater homeowners who actually need the benefits that lower interest rates supply. [For more information on mortgage refinancing for underwater homeowners, see the September 2010 first tuesday article, FHA “Short-Refi Program” debt relief for underwater homeowners.]

first tuesday take: The upward trend of 15-year refis is a simple example of low interest rates helping the rich get richer — not a bad thing generally, but when economic stimulus is limited to benefiting the already well-off, something has obviously gone awry. As it is, only those homeowners who currently have reliable jobs, earn a sizable income and have a positive equity in their property can qualify for refis.

For California, those homeowners most likely to refi on a 15-year FRM probably purchased or last refinanced their home before 2002 (read: pre-boom), since most homes purchased or refinanced after 2002 are currently underwater and not eligible for a refi, 15-year or otherwise. The 15-year refi is being exploited by homeowners who only have 15 to 22 years remaining on their present home loan.

Interest rates are low for one reason: the Federal Reserve (the Fed) is driving them down to encourage spending to stimulate the economy (read: create jobs — the primary task of the Fed). The magic of lower interest rates only works when lower interest makes acquiring cash less expensive, which in turn leads to more lending, increased spending, business development and thus more jobs. [For more information on the role of the Federal Reserve, see the December 2009 first tuesday article, The lender of last resort: understanding the function and methods of the Federal Reserve.]

This use of the 15-year refi runs contrary to the Fed’s plans for reinvigorating the economy. When homeowners choose to refinance at a shorter term while making an equal or greater monthly mortgage payment as they were on their 30-year loan, they render lower interest rates powerless to generate economic growth.  If these homeowners refinanced at a lower interest rate over the same loan term remaining on their previous loan in order to lower their monthly payments, they would create discretionary income and generate greater spending power to purchase goods and services in the marketplace. Rather than seeing the light of day in the marketplace, this greater wealth created by the Fed’s actions by lowering interest rates is simply being buried in homes on a 15-year FRM loan.

Even if we jettison the argument that this wealth should be spent rather than saved (increased saving will never lead to economic recovery, just ask Japan), homeowners should still be wary of sinking more money in their home, which is essentially what a 15-year payoff does. The stability of home prices is far from certain. Judging from the steady, year-long increase in mortgage delinquencies and continuing job losses in California, home prices will likely continue to trend down.

Homeowners would be financially better off, now and in the future, by refinancing their current mortgage for a 30-year FRM at a lower interest rate. Then, if they want to develop wealth, they should place their new-found cash into a savings account, lest they refinance their home for 15 years at an appraised value that continues to drop, which would essentially render both their efforts and the Fed’s pointless. Later, if they wish to pay-down principal on their new mortgage to match a 15-year payoff period, they may do so with savings.

Re: Refinancing into shorter loans” from the New York Times