When to Refinance Rule-of-Thumb

Question: “When does mortgage refinancing make sense, in general? What is the rule of thumb for a refinance, in terms of doing it right?”

To answer this question, you have to identity your primary goal for refinancing. If you’re able to achieve that goal through the refi process, then it might make sense to move forward. I know that’s a bit vague, so let me clarify it for you. Here’s the general rule that makes the most sense to me:

When to Refinance Rule-of-Thumb — If you can lower your interest rate and/or shorten the term of the loan, and you’ll stay in the home long enough to recover the cost of refinancing, then it makes financial sense to pursue it. Generally speaking, of course.

Analyzing the Rule of Thumb

Now that we’ve established a basic rule of thumb for when you should refinance, let’s take a closer look at what it means. The most common reasons for refinancing are to (A) secure a lower interest rate and/or (B) shorten the term of the loan. If you can do one or both of these things, you might be on the right track. But the rule of thumb doesn’t stop there. Achieving one of these two goals is not enough. You must also stay in the home (and keep the loan) long enough to recoup your refinancing costs.

Here’s an example of our when to refinance rule-of-thumb in action. Let’s say I apply for refinancing to get a lower rate, and the lender tells me I qualify for a 5.5% interest rate. This is lower than my current rate of 6.5%, so at first glance the refi seems to make sense. I’ll lower my monthly payment by reducing the amount of interest on my payments. That’s one of the objectives stated in the rule of thumb above.

So I should move forward with the process, right? Not yet. We haven’t addressed the second part of our rule. I must stay in the home long enough to recoup the money I spent to refinance.

Let’s say that my total closing costs on the new loan (including an interest point that I paid) come to around $3,800. By getting a lower rate on the new loan, I’ll save money with a smaller payment each month. But I have to carry those savings long enough to surpass the $3,800 I paid out of pocket. If I keep the mortgage for many more years, I’ll eventually accomplish this. But if I turn around and sell the home in a few years, my accumulated savings will be less than what I paid. In other words, if I sell the home too soon, I won’t even reach the break-even point (much less achieve any long-term savings).

We’ve just seen the when to refinance rule-of-thumb in action. I’ve depicted a refinancing scenario where the homeowner was able to secure a lower interest rate on the mortgage. But the homeowner must then calculate those savings over the remaining term of the loan, and that variable depends on how long they’re going to keep the new loan. If we add in the amount paid in closing costs, we have all of the variables needed to “crunch the numbers” … and to determine if it makes sense to refinance the home. That’s how the rule of thumb works.

If you want to learn more about this subject, check out this helpful article:
When Should I Refinance My Home?