(Updated February 2015)
The 2 percent rule is an old rule-of-thumb for deciding whether or not to refinance your mortgage. It's based on the assumption that, unless you can reduce your interest rate by at least 2 percentage points - say, 6 percent down to 4 percent - refinancing won't be worthwhile and you should hold off.
The reality is, it's not quite that simple, and never has been. And to be sure, it's a very conservative guideline. Here's a look at when the 2 percent refinance rule is fact, and when it's fiction.
For years, homeowners have been repeating the long-held belief that you should never refinance unless your rate will drop by at least 2 percent, or 1 percent at the very minimum. That may have made sense during times of high interest rates and large fluctuations, when refinancing sooner could lead to "rate chasing," frequent refinancing in search of an ever-lower rate and incurring repeated closing costs in the process.
These days, however, the 2 percent rule amounts to the financial equivalent of an old wives' tale. Since the time the rule was in vogue and now, there have been literally billions of dollars needlessly squandered on interest payments by people who may have benefited by a mortgage refinancing.
Sound logic, faulty application
The logic behind the 2 percent rule actually makes good sense. It's based on the fundamental principle that you shouldn't refinance unless you can be sure your eventual savings will recoup your closing costs, including the origination fees, appraisal, title insurance, and the rest of the laundry list of fees that accompany a mortgage refinance. The 2 percent rule assumes that you should be able to recover those costs in two years.
It should be obvious, then, that this reasoning doesn't apply to people who plan to stay in their home longer than two years. Remember, the idea behind the rule is that you want to recoup your closing costs.
Let's say the differential between current rates and your loan rate is 1 percent, but you fully expect to stay in the home for 10 years or more. It would still make sense to refinance even if it took four years, for example, to recoup your closing costs. The key is that you stay in your home at least four years, if not longer. All your savings after that are money in your pocket.
Apply the intent, not the law
A more reliable guide may to be ask how long you expect to stay in the home after recouping your refinance costs. If it's your long-term residence and you plan to be there for 20-30 years or more, you might find it worthwhile to refinance even if you won't recoup your costs for seven years or so. On the other hand, if you think you might move in four years and it will take you three to recover your costs, you have to ask yourself if it's worth refinancing just to obtain what is effectively one year of savings.
A good rule of thumb is whether you can recover your closing costs in four or five years. If you're not planning to move presently, there's a very good chance you'll stay in the home at least that long and recover your costs. You also want to be confident you'll be in the home at least a few years longer than that, so you'll have time to realize some significant savings after you reach the break-even point.
Four or five years is also a reasonably short time in terms of the life of a mortgage - that still leaves plenty of time to enjoy your savings. At the same time, you're likely to find if it takes you much longer than that, say 7-10 years, you may find your monthly savings aren't all that great to begin with, even if you eventually recover your costs.
Another reason not to rely on the 2 percent guideline is that it may not be an accurate reflection of your savings. For example, you may be able to reduce your current rate by 2 percent, but if your closing costs are 6 percent of the loan, how quickly will you be able to recoup your costs? On the other hand, a 1 percent reduction with closing costs that are only 2 percent of the loan may be a pretty good deal.
Furthermore, the rate isn't your only consideration when refinancing. Maybe you've got 20 years left on a 30-year mortgage but can into refinance into a 15-year loan that will pay your mortgage off five years sooner and save a bunch of interest over the long run? Maybe you're currently in an adjustable-rate mortgage (ARM) and would prefer to exchange it for the stability of a fixed-rate mortgage to avoid possible rate increases in the future? Or maybe you need money for a major expenditure such as sending your children to college, putting an addition on your home or unexpected medical bills, and a cash-out refinance can provide the funds at an attractive rate? In all these, getting a lower rate is only part of the equation.
If you're considering a mortgage refinance, use the 2 percent rule as a guide, not as a hard and fast rule. Take into consideration the length of time you plan to be in your home. Be realistic and use common sense when determining when, and if, you should refinance.