When Should I Refinance My Mortgage Loan?

What is the rule of thumb for refinancing a mortgage? When does it make sense? When should I refinance my mortgage in this economy? These are some of the most common questions among homeowners these days. Here are some answers for you.

Many homeowners believe there is some magic rule-of-thumb for refinancing, such as the often-quoted two percent rule. I still see this "rule" mentioned all over the Internet. But it's not very useful. Here's why:

The Classic (and Useless) Rule of Thumb

Let's start with the percentage rule. This one's a classic. Though the numbers vary between 1% and 2%, this is the oldest rule of thumb about when to refinance. The wisdom is this. If current interest rates are at least 1% (or 2%) lower than the mortgage rate you are currently paying, then it makes sense for you to refinance your home.

Simple enough, right? Unfortunately, this rule does not take enough into account. It has so many holes in it, you'd be better off tossing some magic jellybeans in the air and waiting to see how they land. This refinance rule of thumb doesn't consider: (A) how much your closing costs are, (B) what your tax rate is, (C) how long you're going to stay in the home, and other important factors.

In a recent article on the Wall Street Journal site, author M.P. McQueen states that "people who followed the one-point rule could have refinanced five or six times in the last 15 years, paying so much in fees that the savings would likely be wiped out." Exactly.

The Break-even Rule on When to Refinance

Another rule of thumb on when to refinance claims that you should break even. If the money you save in future interest costs equals the money you spend in closing costs, then refinancing makes sense. In truth, you should only pursue a refi when you exceed the break-even point. And you need to factor in a lot of the variables to determine this point.

After all, what's the point of going through all the hassle of refinancing if you only break even on the deal? There's not much point to that. Let's talk about a smarter way to determine when to refinance.

A Rule of Thumb Revised

I mentioned the two-percent "rule of thumb" earlier. This is the most commonly offered advice on the subject of refinancing, but it is flawed advice. As the saying goes, you should only consider a refinance if you can lower your interest rate by two percent or more. People have been saying this for years, just because they read it somewhere or heard somebody else say it. Monkey see, monkey do. Forget this advice. This rule of thumb is far too general to be useful to you.

In truth, there are several factors to consider when deciding when you should refinance your mortgage loan. These factors include:

  • How long you plan to stay in the house (and make payments on the new mortgage)
  • How much lower the interest rate will be on the new loan, after refinancing
  • How much you'll have to pay in closing costs and fees when you refinance
  • Whether or not you plan to do a cash-out refinance

Once you have all of these pieces of the puzzle, you can plug the numbers into a refinancing calculator to see how much you might save. Based on these results, you'll know if it's a good time to get a refi. You can find plenty of these calculators online, on such websites as Bankrate.com, CNN Money and others.

Bottom line: You should refinance when it mathematically makes sense to do so, and when it helps you achieve your desired goal. Some people use refinancing to secure a lower interest rate on their mortgage, thereby saving money. Others use it to eliminate other high-interest debts, such as credit cards. So your first step is to figure out what your financial goals are, and then determine whether or not refinancing will help you achieve those goals.

A Refinancing Calculator Worth Using

Forget about using some arbitrary when to refinance rule of thumb. Most of them are worthless. They just don't bring enough considerations onto the table. Instead, try using a mortgage refinance calculator that looks at the bigger picture.

Here's a good example:
http://zwicke.nber.org/refinance/index.py

The Optimal Mortgage Refinancing calculator (above) was designed by economists, and it looks at a broader range of factors to determine when it makes sense to refinance.

At a minimum, you will have to enter your remaining mortgage balance, the number of years left in your mortgage term, current interest rate, your income tax rate, and the total closing costs on the new mortgage. Based on this information, the calculator will tell you the ideal interest rate you would need on the new loan.

Of course, you'll have to get some refinance quotes from lenders, in order to run the numbers through a calculator. The interest rate you get on the new loan is a key part of the equation, so you'll need to find out what kind of rate you can secure.

Here's the key to all of this mortgage math. In order for a refinance to make sense, the amount you save must exceed the amount you pay (in closing costs). Anything short of this mark, and you should not bother with it. This is often referred to as the break-even point, or BEP.

Conclusion and Summary

Here's the definition of a rule of thumb, from the Merriam-Webster dictionary: "a general principle regarded as roughly correct but not intended to be scientifically accurate." This says it all. It's thought to be roughly correct ... but you shouldn't take it too seriously. The same can be said for most of the when-to-refinance rules of thumb you find online these days. They might give you a starting point for further consideration, but that's about it.

If you want a better indicator of refinancing success, you need to consider additional factors that most calculators ignore -- such as your tax rate, the length of time you'll be in the home, and the total amount of closing costs. Put all of these factors into the mix, and you'll have your answer.

Disclaimer: This article discusses the rule of thumb about when to refinance a mortgage loan. This article is intended for educational purposes only. We are not acting as your financial advisor. If you are thinking about refinancing your home, you might want to speak to a financial advisor or housing counselor to further explore your options.

This article answers the common question, When should I refinance my home mortgage? To learn more about this topic, check out this related article: Average Cost to Refinance a Home

I hope this lesson helps you determine when it makes sense to pursue a refi loan, and I wish you well in your financial pursuits.