The Simple Dollar is running a series in which we re-evaluate Money Magazine’s “25 Rules To Grow Rich By”. One “rule” will be re-evaluated each weekday until the series concludes; you can keep tabs on the action at the 25 Rules index.
Rule #2: It’s worth refinancing your mortgage when you can cut your interest rate by at least one point.
Rules of thumb fail miserably when evaluating a complex, multi-dimensional situation such as the decision on whether to refinance. For example, the reasons to refinance might include simply reducing your mortgage’s interest rate, outstanding debt consolidation, reducing the term to build home equity faster, or to use the home as leverage for a major purchase. Each situation provides different rules for evaluation, but is there one central principle that can be extracted from this mess?
If your only goal is to refinance to reduce interest, it’s likely that this rule of thumb will work perfectly for you. In this competitive housing market, many lenders have reduced refinancing costs to the point where a 1% drop in interest early in the loan’s life can indeed save money over the loan’s life. If you can beat a 1% reduction, even better.
But let’s say you have $20,000 in outstanding credit card debt at 15.99% APR, and you want to refinance to lower this interest rate. In this case, it might actually make sense to refinance at the same rate as your current house if the closing costs can make up the difference between your home loan rate and that awful high credit card APR.
What if you want to reduce your term to build equity faster? If you’re very early in your loan’s lifecycle, even a half-percent drop in interest along with a reduced term can end up saving you money on the overall life of the loan. Your monthly payments might be higher, but your total payments would be lower.
In short, the only rule of thumb that applies to refinancing is that you’re saving money in the dimension that you’re concerned about, no matter what that dimension is. When you’re considering a home refinancing, don’t just jump at that 1.5% lower rate; sit down and carefully run the numbers to make sure that you actually will save money. Let’s rewrite that rule:
Rewritten Rule #2: It’s worth refinancing your home only if you can reduce your overall costs including the added refinancing costs.