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The “Should I Refinance” Rule of Thumb

If you’re considering mortgage refinancing you may have heard of the two percent rule of thumb. This mortgage refinance rule states you should only take out a new home loan if the interest rate is two percent lower than your existing rate. Is this the best approach for answering the question should I refinance my mortgage or are you leaving cash on the table? Here’s a better way to base your mortgage refinancing decision and help you avoid paying too much in the process.

The Should I Refinance Rule of Thumb

Refinance rates are hovering near four percent, the lowest levels in sixty years. If you’re currently paying six percent or more on your home loan then the two percent rule applies to you but what about everyone else? If you’re paying 5%, even 4.5% you can still benefit from mortgage refinancing. Answering the question “Should I Refinance” based on a two percent drop in your interest rate is walking away from a lot of money.

Here’s how to make an informed decision if mortgage refinancing is right for you without leaving cash on the table.

This example illustrates the problem with the “two percent rule.”

  • Mortgage Loan Amount: $400.000
  • Term Length & Rate: 30-year fixed-rate @ 5%
  • Refinance Mortgage Rate: 4.25%
  • Refinance Closing Costs: $4,000

In this example the monthly payment at 5% is $2,147. Refinancing with today’s best mortgage lenders could get you an interest rate as low as 4.25% which lowers your payment to $1,967. This is a savings of $180 per month BUT mortgage refinancing will cost you four grand. Is it worthwhile?

Debunking The Two Percent Rule

In this example it’s going to take about 23 months to break-even recouping your out-of-pocket expenses. (divide $4,000 by the $180 you’re saving each month)

This is a reasonable amount of time to recoup your closing costs so if you’re answering the question should I refinance in this way it makes sense. In this example we were refinancing a large home loan, $4,000. If you’re refinancing a lesser amount you’ll still want to run the numbers before answering the question should I refinance because the amount you’ll be saving each month will be less and it will take longer to break even.

If you decide to sell your home or refinance again before recouping your closing costs you’re going to lose money no matter how low interest rates fall.

How to Avoid Unnecessary Points & Junk Fees

As you can see your closing costs decide how long it’s going to take to break even recouping closing costs and therefore how good of a deal you’re getting. One strategy for getting the most benefit from mortgage refinancing is to pay as little as possible at closing. Sure there are no free refinance options; however, you’re giving up low refinance rates in exchange for having your closing costs paid.

The best way to maximize your benefit from low refinance mortgage rates is to avoid paying discount points and lender junk fees. Discount points serve to lower your interest rate. Why pay a fee when rates are at the lowest levels in sixty years and discount points only push your break-even point further away?

Lender junk fees like application and processing fees or overpaying the origination fee do the same thing. You shouldn’t be paying more than one percent for the loan origination fee and I’ve even seen some small credit unions charge as little as .28 percent. Shopping for both refinance rates and fees will make sure you’re breaking even in the least amount of time and maximizing your benefit from the new home loan.

Shorten Your Term Length Whenever Possible

Once you’ve answered the question Should I Refinance, another strategy for saving money is to lower your term-length. The term of your home loan is the amount of time you have to repay the mortgage and along with your refinance rates determines your payment amount.

One common mistake is going from a 15-year to a 30 or even 40-year mortgage. If you do this the calculation we’ve been using to find your break-even point is no longer valid. In these cases you’ll never break even and will be losing a boatload of cash because on the interest you’re paying for those extra years.

Shortening your term-length allows you to build equity in your home at an accelerated rate and saves you thousands of dollars per year in finance charges. Government programs like HARP 2.0 encourage shorter term-lengths for this very reason. This is why you should consider a 15-year or even 10-year mortgage if you can afford the higher payments.

If you need help with the math when answering the question should I refinance, leave a comment below and I’ll be more than happy to lend a hand.

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You can learn more about saving thousands of dollars on your next home loan by avoiding junk fees and markup by checking out my free Underground Mortgage Videos.

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{ 6 comments… add one }
  • Beverly March 27, 2012, 1:19 pm

    I have a HELOC that I am using to do repair and minor remodeling on my house (on which I have no mortgage) so I can refinance the HELOC as a regular mortage (probably 30-year). The HELOC is thru a local regional bank branch, and of course they will encourage me to do the refinance there. However, I think I should probably do rate checking at other banks and credit unions in the area. In order to not lower my credit score which is above 740, I have heard you need to make these inquiries in a very short amount of time in order for the credit inquiries not to lower my score. What is the best quote to ask for, 1 pt, 2 pt, zero pts or all 3? I want to refinance for 30 years since right now I need a lower monthly payment. As my income increases, I will start paying extra on the principle. Can you give me the most important things to say when I make my calls, and also how many banks & /or credit unions should I call? Thanks so much for your help. I’ve never had to do anything like this on my own and am in desperate need of coaching on how to handle this.

  • Lisa April 3, 2012, 8:35 am

    I have an FHA mortgage, which I have been paying for 15 years with 15 years to go. My interest rate is 7%. I haven’t had my home appraised recently, but I would guess that its value is approximately $85,000, and the mortgage balance is $43,000. I would like to refinance and cash out some equity to repair my roof and pay off $12,000 in credit card debt. I was told a few years ago by a mortgage company employee that I wouldn’t gain anything by refinancing my mortgage because we had paid most of the interest already. What can I do to find out if that is true? I’m trying to get out of debt as quickly as possible, not dig myself in deeper.

    • Robert Regehr April 3, 2012, 10:44 am

      Hi Lisa. It’s true that mortgage refinancing resets the clock on your loan amortization and you’re right back to paying mostly interest every month. That being said if you’re currently paying 7% you absolutely would benefit from refinancing at 4% because you’re stuffing significantly less money in the lender’s pockets. If you’re considering cash-out to make essential repairs like fixing your roof it becomes a question not of should I refinance but where can I get the best deal on fees. The closing costs make or break the deal you’re getting regardless of your interest rate. The less you pay for loan origination and other fees the quicker you’ll break even recouping your out-of-pocket expenses and benefit from that 4% mortgage rate. If you’re able to consolidate the $12,000 in credit card debt that you’re probably paying double-digit interest on that’s also a win. Find a good mortgage broker that you trust and they’ll get a good deal for you. If you’re a member of a community-based credit union that’s also a good starting point.

  • Josh April 3, 2012, 9:43 pm

    Hi Robert, I just found your website and really appreciate the info. You wouldn’t believe how much lower of a rate I’ve already been quoted. What do you see rates in the short term doing, next couple months?

  • Kate Emery April 23, 2012, 7:30 pm

    Very helpful info – great site! How to determine if mort broker is broker bank? How to know what ysp broker charging me? Can I nego orig pt down from 1%? How & where to get par rate. Current mort in amt of 121000 @ 5 7/8%, payoff 2033. Credit rating well beyond 740. Per your info I am thinking 15 yr w/ no cash out(addtnl) but need remod so may rethink. Would very much aappreciate any guidance.Much gratitude for site! Kate

  • Olivia Smart January 5, 2022, 12:24 pm

    Thank you for explaining that shortening the term of your home loan can help you to build equity in your home. My husband and I have been debating whether we should refinance our mortgage to a shorter term length, but we’ve been back and forth on it. After learning a bit more about how we can build equity, we’ll have to give it a serious discussion since it seems like it could be a great idea.

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