The Refinance Rule of Thumb

March 21, 2012 5 Comments »
The Refinance Rule of Thumb

How Much Lower Should Mortgage Rates Be to Refinance?

If you’re considering refinancing your mortgage, you may have searched for the “refinance rule of thumb” to help you make your decision.

Of course, there isn’t a single refinance rule of thumb. There are numerous ones. And before we dive into them, it should be noted that rules don’t tend to work universally.

What works for one person might not work for another, and if you’re relying on some sort of shortcut to make a decision, you might wind up shortchanging yourself in the process.

That being said, let’s look at some of these “rules” to see if there are any takeaways we can use to our advantage.

Only Refinance If the New Mortgage Rate is 2% Lower

One popular one is that you should only refinance if your new interest rate will be two percentage points lower than your current mortgage rate.

For example, if your current mortgage rate is 6%, that rule would tell you refinance only if you could snag a rate of 4% or lower.

But clearly this rule is much too broad, just like any other rule out there. When it comes down to it, a refinance decision will be unique to you and your situation, not anyone else’s.

This old rule assumes most mortgage amounts are pretty small, unlike the jumbo loans we see nowadays.

Let’s take a look at some math to illustrate why this refinance rule falls short:

Loan amount: $500,000
Loan type: 30-year fixed-rate mortgage
Current mortgage rate: 5%
Refinance mortgage rate: 4%
Cost to refinance: $4000

In this scenario, the existing mortgage payment is $2,684.11. If refinanced to 5%, the monthly mortgage payment falls to $2,387.08. That’s a difference of nearly $300 a month, which will certainly make it easier to meet your mortgage obligation.

However, it will take 13 months to recoup the cost of the refinance ($4000/$297).

That said, the refinance “breakeven period” (time to recoup your costs) is very short here. So we don’t need to follow that “2% lower rate” refinance rule.

But what if the loan amount is only $100,000? The game changes in a hurry. Your mortgage payment would drop from $536.82 to $477.42. That’s roughly $60 in monthly savings, not very significant.

[Check out these mortgage payment tables to quickly eyeball differences in rate.]

Assuming the cost of the mortgage was still somewhere around $3,000, it would take 50 months, or more than four years, to recoup the costs associated with the refinance.

So if you were thinking about selling your home in the short term, it probably wouldn’t make sense to throw money toward a refinance.

This is probably why this old refinance rule exists. But home prices are much higher these days, so it’s not a good rule to follow for everyone.

The same goes for any other mortgage rate rule that says your rate should be 1% lower, or 0.5% lower. Whether it’s favorable or not really depends on a number of factors, such as the loan amount, closing costs, and expected tenure in the home.

If we don’t know the answer to all those questions, we can’t just throw out some blanket rule for everyone to follow. Again, don’t cut corners or you could find yourself in worse financial shape.

Only Refinance If You’ll Save “X” Dollars Each Month

Another common refinance rule of thumb says only to refinance if you plan to live in your home for “X” amount of years, or only to refinance if you’ll save “X” dollars each month.

Again, as seen in our example above, you can’t just rely on a blanket rule to determine if refinancing is a good idea or not.

Some borrowers may need to stay in their home for five years to save money, while others may only need to stick around for just over a year.

But plans change, and you may find yourself living in your home much longer (or shorter) than anticipated.

And if you look at the refinance savings in dollar amounts, it will really depend on the cost of the refinance and how long you make the new payment.

If it’s a no cost refinance, you won’t even have to worry about the break-even period.

So it’d be foolish to get caught up on this rule unless you have a bulletproof plan.

[Does refinancing hurt your credit score?]

Forget the Rules, Consider the Term

Finally, consider the mortgage term when refinancing, and the total amount of interest you can avoid paying over the life of the loan.

If you’re currently five years into a 30-year fixed mortgage, and refinance into a 15-year fixed mortgage, you’ll shave 10 years off your aggregate mortgage term.

Assuming mortgage rates are low enough at the time of refinance, you could even wind up with a lower monthly payment despite the shorter term.  You will also build equity faster and greatly reduce total interest paid, which will shorten your break-even period and maximize your savings.

[30-year mortgage vs. 15-year mortgage]

If you simply refinance into another 30-year loan, you must consider the five years in which you already paid interest when calculating the benefits of the refinance.

Also factor in your current loan type versus what you plan to refinance into. If you’re currently holding an adjustable-rate mortgage that will reset higher soon, the decision to refinance may be even more compelling.

At the end of the day, you shouldn’t use any general rule to determine whether or not you should refinance.

Doing so is lazy, especially when it’s not that difficult to run a few numbers to see what will make sense for your particular situation.

If you feel overwhelmed by all the math, ask a loan officer or mortgage broker to run some scenarios for you to illustrate the potential savings and break-even periods. Just be sure they’re giving you an accurate and complete picture and aren’t simply motivated by a paycheck.

And take your time – you’re not shopping for a big screen TV, you’re making one of the biggest financial decisions of your life.

Tip: When to refinance a home mortgage.

(photo: angermann)

5 Comments

  1. Michael March 22, 2012 at 6:24 am -

    Your 1st example comparing a $100K mortgae @ 4.0% vs. 5.0% is not taking into account that the 4% is going to pay more every month towards your principal so you have to add that amount (your $) to the out of pocket.

  2. Colin Robertson March 22, 2012 at 9:14 am -

    Good point Michael, which is all the more reason why you can’t rely on a single rule to refinance.

  3. Henry July 26, 2013 at 10:13 am -

    I ran a number of calculations and found that a refinance no longer made a lot of sense for me and my family. Now that interest rates are more than 1% higher than they were in May, I think I’m better off just sticking with my current loan, especially because I’ve had it for nearly 10 years. My guess is that a lot of people are refinancing just to lower their monthly payment, but they will actually pay more in interest throughout the longer loan term.

  4. John August 5, 2013 at 3:29 am -

    If you refinance, make sure you shorten your term too if you’ve already paid down your mortgage for several years. Or don’t refinance at all and just make extra principal payments! Simple way to cut interest expense.

  5. Bryce April 3, 2014 at 9:46 am -

    Some people just want a lower monthly payment, even if it means more interest over time. So it depends what your goal is in refinancing.

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