Refinancing in Today's Environment

The financial formulas used in the past to help homeowners make mortgage refinance decisions may be obsolete. Before refinancing, it's important to put the decision into an updated and accurate perspective.

Many homeowners consider refinancing whenever rates drop. Those who ask around discover that numerous experts recommend refinancing anytime it's possible to lower the rate by at least two percentage points. But that famous formula is outdated. Applying it to today's refinance market may actually inspire homeowners to avoid refinancing even when it can save them money.

Refinancing's old rules

The problem with the old mortgage refinance equation-often referred to as the "two point rule"-is that it was created when mortgages and refinancing costs were generally higher than they are today. To illustrate just how much the market has changed in a very short time, any rate that was 10 percent or less used to be considered historically low. Many homeowners today-especially the younger ones-have never seen 10 percent interest rates, and consider that benchmark extremely high. But in the late 1970s, for instance, rates climbed into the high teens and sometimes even broke a few points above 20 percent.

Doing the math

In the old days, if you refinanced a mortgage with an interest rate of 12 percent to one with 10 percent (two points), you'd have saved the same percentage as you would today by reducing a 7 percent mortgage to around 6 percent-which is only one point. Now, look at it in reverse. If you reduce an 8 percent loan to 6 percent, which is recommended by those adhering to the 2 percent rule, the percentage reduction (25 percent) is roughly equal to reducing a 16 percent loan to 12 percent-four points. Everyone would agree that it's not wise to wait until rates drop four points before refinancing.

Consider closing costs

Another thing to consider when pondering a mortgage refinance is that there are significant closing costs involved. Until those are paid back through the savings generated by a lower monthly payment, you won't break even. If you plan to sell your home before the break-even date, it doesn't make sense to bother refinancing. Some lenders now offer discounted packages that charge a fixed fee for a refinance, while others itemize costs. Shop around for the cheapest rate while also being careful to shop for lower closing costs. Then factor both into your potential savings.

Everyone's financial situation is unique, and everyone has a different plan for staying in her home, or selling it to relocate. That's why it's important to forget the one-size-fits-all formulas. Crunch all the numbers to find out exactly how much a refinance can save. Then, figure out how many months it will take to break even, and compare that to your future plans. If you can save money in a timely manner, do the mortgage refinance. Otherwise, don't bother, because you'll simply be wasting money.