The mortgage industry is full of interesting little rules of thumb. When it comes to refinancing, you may have heard of the 2 percent rule.
The 2 percent rule is one of those clichés that has taken on a life of its own. The rule applies to refinancing and is almost always misused. The rule essentially says that if there is not a 2 percent spread between your current interest rate and the rate for the refinance, you should not go ahead. This is so much nonsense.
The 2 percent rule was never intended to be applied as a blanket guideline for refinancing. Instead, it should be used as a gauge. The 2 percent rule isn’t so much about the interest rate as it is about how long it takes to recover the cost of refinancing. The 2 percent represent a rough estimate of how long it will take you to recover the cost of refinancing in two years. If you pay points, appraisal fees and so on, a 2 percent spread will take about two years to recover said cost.
The application of the 2 percent rule is heavily overused and incorrectly so. For instance, many refinance loan packages now are low or no cost. In such a situation, you obviously are not going to need two years to recover the cost. In short, the rule is wrong.
Even if you pay all kinds of cost, focusing on two years is a mistake. Most people do not refinance if they plan to sell a home in a year or two. There isn’t any point. If you intend to live in your place for the next five years, who cares if it takes two years to recover the costs associated with refinancing? You are going to save money from year three through five!
Another area where the 2 percent rule fails is the type of loan. If you have an adjustable rate loan, you should be considering a switched to a fixed product before rates go up. In such a situation, any rate increase on your adjustable is going to far outweigh the costs of refinancing into a fixed loan.
There is a lot of hype about the merits of the 2 percent refinance rule. Don’t fall for it. Figure out your situation and see if refinancing makes sense.
Dan Lewis is with Great Western Mortgage -
mortgage brokers providing home loans.
