When to Refinance Rule of Thumb
Refinancing your mortgage to a lower, more affordable rate sounds like a great deal. But before you make any decisions to do so, it’s important for you to understand the “when to refinance rule of thumb”. Too many people get seduced by hearing about the super low rates available today. Considering the state of the economy and of many people’s personal financial situation, of course it sounds good to refinance your mortgage to lower your rate and save you money. But are you really going to be saving money? Let’s look at a few things you may have heard, but that aren’t quite on target.
The old standard ‘rule of thumb’ for refinancing stated that if you could reduce your interest rate by 2% or more, then it made financial sense and you should move forward with a new loan. Another common standard calculation was as vague as saying that as long as you could achieve a ‘significant’ savings to your monthly payment (they stated that $200 a month was enough for ‘most’ people), and that you weren’t adding more than 5 years to the term of your loan, then you should go for it.
The basic question that needs to be asked, and that is quite honestly NOT asked very often, is, “How long do you plan to be in this house (or more specifically, on this mortgage)?” You see, if someone knows that they will be moving in a year, I don’t care how much of a monthly savings they can get… It’s probably not going to make sense to refinance!
Remember, when you refinance your mortgage, you’re getting a whole new loan. This means that you have to go through all the steps, all the processes, and all the costs involved as when you got your first mortgage (well, except for a home inspection that you probably had to pay for when you purchased the home. That will not be necessary in a refinanced loan). You will need to pay for an appraisal, Title and escrow fees, origination fees, etc. Depending on the size of your home loan and where you live, these costs could easily add up to several thousand dollars.
This is where you need to begin calculating whether this will make sense for you. You need to know where your break-even point is in relation to the monthly savings you will gain as opposed to the up-front expenses you will incur to get the new loan.
Let’s look at some simple numbers as an example. Let’s say that it would cost you $3000 in expenses to get a new home mortgage. Whatever your current rate is or your new rate would be, let’s also say that you would be saving $200 per month. If you divide 3000 by 200 you get 15. That means that it will take you 15 months to break-even. In other words, your $200 monthly savings every month takes 15 months before it covers the expense incurred of $3000. From the 16th month on, you are truly saving $200 per month.
As you can see, if this was your scenario and you knew that you were going to be moving out of your house within a year, you wouldn’t have time to recover the money you spent with the money you are ‘saving’. After 12 months, you would have ‘saved’ $2400… but remember, you spent $3000 to get those savings!
You can never know exactly what the future holds. However, you can often get a general sense of whether or not you think you will be in your current home for a year, a few years, or for many years to come. Make sure to factor that into your equation when you are looking to find the answer to your own personal “When to refinance rule of thumb.”
