When Should You Refinance Your Mortgage, According to the Rule of Thumb?

Homeowners are frequently encouraged to refinance their mortgages while interest rates are low. In fact, many mortgage advertisements recommend refinancing to save money by taking advantage of historically low-interest rates. The basic rule is that you should refinance when interest rates are at least 1% lower than your current rate. However, that isn't the only factor to think about. We'll go over the benefits and drawbacks of using the 1% rule of thumb for refinancing, as well as show you some examples and explain another mortgage rule of thumb to help you weigh your options. Important Points to Remember

The 1% rule of thumb is merely a rough guideline for refinancing.
The bigger the rate reduction, the more money you can save.
Refinancing can be a reasonable option when the rate difference is less than one percent.
Refinancing isn't only about saving money on interest.
As crucial as the rate is the break-even point.

What Is the Refinancing Rule of Thumb and How Does It Work?

Suppose you can get an interest rate that is at least one percentage point lower than your current rate. In that case, you should consider refinancing your home according to the 1 percent refinancing guideline. It is recommended that the new rate be as low as feasible. "A [1%] drop in rate saves you roughly $280 per month or $3,360 per year on a $500,000 loan," Melissa Cohn, an executive mortgage banker at William Raveis Mortgage, told The Balance via email.

Why Does the 1% Rule for Refinancing Work in Most Cases?

When deciding when to refinance, it's a good idea to utilize a 1% rule of thumb since you might save thousands of dollars each year. "If you have a conforming loan and closing costs are around $6,000," Cohn explained, "it will take just under two years to break even and actually take advantage of the refinancing savings." Note: When loan rates drop even slightly, some homeowners get enthralled by the prospect of refinancing. However, your savings will be minimal if the rate is less than one percentage point lower than your current rate. Consider refinancing a $200,000 loan with a 6.0 percent interest rate and a monthly payment of $1,199. Here's how much money you'd save if you refinance to get 0.5 or 1 percentage point cheaper rates.

Refinance to a 5.5 percent interest rate
Refinance to a 5% rate
$1,136 per month $1,074 per month
$63 per month in pre-tax savings, $125 per month in post-tax savings
$756 per year in pre-tax savings, $1,500 per year in post-tax savings

Your savings, however, will not all end up in your wallet. Fees for refinancing, closing costs, and prepayment penalties would all have to be deducted from the total. According to Freddie Mac, closing costs are estimated to be roughly $5,000 on average. When these fees are factored in, the potential savings from refinancing at a rate that is less than one percentage point lower than your present rate may not be worth it.

Other Things to Think About

The 1% rule of thumb does not account for all aspects of a mortgage. According to Cohn, even if the new rate is less than one percentage point lower than your current rate, it may be worthwhile to refinance a jumbo loan. Jumbo loans, also known as non-conforming loans, were loans worth more than $548,250 in 2021, rising to $647,200 in 2022, and refinancing a larger loan after a 0.5 percent this way, you might save a lot of money by lowering your rate. Refinancing for other reasons may not result in instant savings. "If you have an adjustable rate, you might wish to refinance to a fixed rate to benefit from the rate being locked in for the long term," Cohn suggests. Otherwise, your monthly payment would fluctuate with the current interest rate, and some mortgages even have a ceiling on how low your interest rate can go. Some consumers refinance to a shorter term in order to pay off their mortgage faster, according to Cohn. You might refinance a 30-year mortgage into a 15-year loan. "Refinancing can also work if you have a HELOC (home equity line of credit) and want to merge the first and second [loans] into a new first mortgage," she stated. "It's just a matter of how long you anticipate you'll stay in your house and how long it will take actually to profit from the refinancing," Cohn said when it comes to determining whether or not to refinance.

Refinancing Rule of 1% vs. Break-Even Point Rule

The 1% refinancing rule of thumb is the right place to start, but it should be weighed against the break-even point rule of thumb. "This rule of thumb is based on how long it will take you to break even on the refinancing, based on closing fees and savings," Cohn noted. This is when you'll start saving money after you've paid off your refinancing fees. As a result, you should consider how long you plan to stay in the house as part of your refinancing choice. Let's return to the previous case of refinancing a $200,000 mortgage from a 6% interest rate to a 5% one. After taxes, you'd save $125 every month, for a total of $90. However, assume that your new mortgage fees and closing charges total $2,500. To break even will take 28 months if you divide your expenditures ($2,500) by your monthly savings ($91). Refinancing your mortgage might not be worth it if you don't plan on staying in the house for a long time.