Forget the 'Two Percent Rule' for Refinancing

Discussing finances

You may have heard that interest rates are on the rise. In fact, it was one of the biggest financial stories of the summer and all the economic pundits couldn't wait to get their two cents heard on a television program or appear in their blogs. Yes, rates did go up earlier this year and statistically it was one of the largest month to month increases in a couple of decades. If you were thinking of refinancing your mortgage and heard this news, and it's likely you did, you may have thought it was no longer worth refinancing your VA loan.

Here's what happened. 30 year mortgage rates hit record lows (again) in January of this year. In May, 30 year fixed rates were around 3.50 percent and in June they rose above 4.50 percent. That's more than a full percentage increase in just one month. But remember where rates were in the first place, near record lows. A full percentage point sounds ominous but rates are still around 4.50 percent. That's still far better than four years ago when rates were around 5.25 percent and 6.75 percent in 2007. If you've had your current mortgage for longer than three years, you still need to pick up the phone and talk to a VA loan officer about refinancing.

It's Not About the Rate

Why? Because refinancing isn't about the interest rate. It's been a financial myth for years about refinancing a mortgage that rates have to fall two percentage points or one percentage point or whatever before it makes sense to refinance. But what is an interest rate, really? It's a function of your monthly interest charge and ultimately your monthly payment. You're refinancing to a lower payment, the rate is just a vehicle.

Let's step back for a second and look at two loans.

A loan amount of $75,000 at 6.00 percent refinancing into a 4.00 percent loan.

Current payment: $450 per month New payment: $358 per month

That's a savings of $92, not bad.

Let's increase the loan amount to $375,000 and look what happens:

Current payment: $2,248 New payment: $1,790

That's a savings of $458 per month. The rate difference is the same but the loan amount and payments are wildly different.

Now one more time but let's refinance the larger loan from 6.00 to 5.25 percent, or 0.75 percent lower.

Current payment: $2,248 New payment: $2,070

The interest rate differential is only 0.75 percent, does the "two percent rule" apply here?

Closing Costs

To see if a refinance makes sense, you have to take the closing costs into consideration. You can always drop a monthly payment but there are additional fees at the same time. Say the closing costs on the smaller loan add up to $2,100. The difference in monthly payment with a refinance from 6.00 to 4.00 is $92. If you divide $2,100 by the $92 savings, the answer is 22 (months). As long as the owner keeps the mortgage for at least 22 months, it makes sense to move forward with a refinance. After all, it was a full 2.00 difference in rate, right?

But it's not about the rate. Now say the closing costs for the $375,000 add up to $4,350 and the savings from 6.00 to 5.25 is $178 by dividing the savings into the closing costs the answer is 24. As long as the owner keeps the mortgage for at least 24 months, it makes sense to refinance.

And the rate in this example only dropped by 0.75 percent. Forget the "two percent rule." It's not about the rate—it's about the savings.

Story Continues