The long-held belief that you should never refinance unless your rate will drop by 2 percent has been passed down by generations of homeowners. Unfortunately, it amounts to the financial equivalent of an old wives' tale. Between the times when the rule was created and now, there have been millions of dollars foolishly squandered on interest payments by people who may have benefited by a mortgage refinancing.
Sound logic, faulty application
The intent of the 2 percent rule is good. Basically, the original advice was that you shouldn't refinance unless you can recoup your closing costs, including the appraisal costs, title insurance, and the rest of the laundry list of fees that accompany a mortgage refinance. The 2 percent rule assumes that it takes two years to do so.
However, this reasoning doesn't apply to people who plan on staying in a house 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 less than 2 percent. It might still make sense to refinance if it takes 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.
Apply the intent, not the law
Ultimately, when you consider a home refinancing, you should factor in the length of time you plan on staying in the house. If it takes 15 years to recoup your closing costs, you may want to hold off on the loan, considering that most people move approximately every five years.
You should also consider whether or not you might need to tap your equity for upcoming expenses. For example, if you're going to send your kids to college in the next three or four years and have little or no savings to pay for it, refinancing right now might not make sense. You may want to wait and see if you'll need to tap into your equity for a higher education. At that point, you could pick another type of loan (an adjustable-rate mortgage with a low teaser rate, for example), to get a palatable interest rate.
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.
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