When You Should Refinance Your Mortgage Loan

May 10, 2013

refinance mortgageThere are different times when you should refinance your mortgage loan, but contrary to popular belief lower interest rates are not the only reason. Sure, when interest rates hit new lows millions of homeowners flock to refinance their homes. But there are also times when you should refinance when rate is not the driving force.

When should you refinance your mortgage loan?

1. When mortgage rates are at least 2% below your current rate.

This rule was more important when interest rates were higher. But it served two useful purposes. First, it set a standard as to when you should be looking to refinance. If your interest rate was 10%, and rates were dropping, you would know to look more seriously once interest rates dropped to the 8% level.

The second purpose was probably to avoid serial refinancing. Back when interest rates were higher, and especially when they were in double digits, it wasn’t unusual for mortgage rates to swing by 1% or more in a short space of time. By setting the threshold at a 2% rate decline, you could avoid refinancing every time rates dropped by a point. Since refinancing often comes with hefty closing costs, refinancing too often could cost you more than you would save.

A 2% drop in rates is extremely unlikely when mortgage rates are already below 4%, so this rule has pretty much fallen into obscurity. But rest assured that it will be back when we return the higher rates.

2. When you can recover your closing costs in 24 months or less.

This one is the gold standard of refinance rules. It focuses on closing cost recovery. And as the name implies, it recommends refinancing only when the savings in your monthly payment will be sufficient to recover your closing costs in not more than 24 months.

For example, let’s say that you have a $100,000 loan, and you have an opportunity to lower the monthly payment by $150. If the closing costs on the loan are $5,000, it would take you proximally 33 months to recover them ($5,000 divided by $150). The refinance would not be worth doing.

Using the same example, if the closing costs were just $3,000, you would be able to recover them in 20 months ($3,000 divided by $150). That refinance would be worth doing.

Some homeowners – and many mortgage loan officers – might play fast and loose with this rule. For example, they may ask, “how long do you expect to be in the house?” If you say that you think you will be in the home for at least another five years, they might convert the 24 month rule into the 60 month rule. That is to say, as long as you can recover your closing costs within five years, the refinance will be worth doing.

On some level that may sound logical, but it really is a stretch. While it may be possible to expect you’ll be in a home for the next two years, the anticipation that you’ll be there for five years requires a fully functioning crystal ball. You may intend to be there for five years, but if you get a job in another city, or lose your job because of economic conditions, you may have to move much sooner. In addition, for any number of reasons you may also decide to refinance again within five years. In that case, at least part of your closing costs on the last refinance will go up in smoke.

Stay with the 24 month rule, and avoid morphing it into something longer. The farther out you go with projections, the less likely it is that they will be accurate.

3. When you want to pay off your mortgage early.

Here’s where we get into a consideration that has a lot less to do with rate. If you want to pay your mortgage off early, but don’t think that you have the discipline to make optional higher principal payments, you might want to refinance to shorten your loan term. This will force you to pay off your mortgage in less time than your current mortgage will allow.

If you are in a financial position to take on a higher monthly payment, you may convert your 30-year loan to a 15-year term simply so that you can pay it off quicker. The rate may even be a little bit higher than what you’re now paying, but you might opt to do it anyway.

There is yet another reason why rate is less of a factor when you are refinancing to a shorter term loan. Interest rate is less of a factor on shorter-term loans because more of your payment is principal.

4. When you need to get out from under a high payment.

This scenario is the exact opposite of the one above. You may have a 15-year mortgage that you are struggling to make your monthly payments on. Or you might be facing the prospect of a pay cut or a job loss. Whatever the reason, you might have a need to lower your house payment.

The quickest and easiest way to do that will be to refinance your 15-year loan into a 30-year loan. You will of course be extending the amount of time it will take to pay off your loan, but the reduction in payment could be the difference between keeping your home and losing it.

And for what it’s worth, yes, people actually do refinance 15-year loans into 30-year mortgages. It sounds like reverse logic, but sometimes you have to do what you have to do.

Have you ever decided to refinance based on any of these reasons, especially the last three? Leave a comment and tell us about it!


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Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids and can be followed on Twitter at @OutOfYourRut.

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8 Responses to When You Should Refinance Your Mortgage Loan

  • Kirk Kinder

    Great article. Focus on the closing costs as so many people neglect to think about those. When you can roll them into the loan, people ignore the true cost and focus solely on the monthly payment.

    • Kevin

      Hi Kirk–Lenders roll them in precisely to make them go away. It’s sad, but payment is all that matters in so many businesses. People mistakenly believe that if the payment is pretty then all is well.

      I’ve even heard it said in the car business “we’re not selling cars, we’re selling payments!”

  • Kevin

    Hi Robert – if it improved the chances of your paying off the loan ahead of schedule than it was worth the move. You also seem to be a lot more settled in your house than many homeowners are, in that you have a long term plan to pay it off early.

  • Robert Jacobs

    I used the first three when deciding to refinance the first time. Three years later I did it again but my rate wasn’t 2% less than the current rate, it was 1% less and it made my break-even point at 30 months. Regardless, it made our payment lower, reduced the payment, and overall made it worth it since we want to have it paid off early in 5-7 years.

  • Long

    The 2% rule you wrote about is not necessarily a good yardstick. I’ve refinanced for less than that twice. In fact, I have refinanced for .25% and had a very short break-even period because I was able to negotiate very good terms with the lender.

    My opinion is that the break-even period and how long the homeowner intends to stay in the home are the most important factors.

    • Kevin

      The 2% rule applied more when rates were in double digits. It’s too high for todays rates. Still, I don’t think I’d be interested in refinancing for .25%.


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