Refinancing Rule of 5s: Deciding If Refinancing Is Worth It

May 17, 2010 — -- Have you heard? Mortgage rates hit their lowest point of the year last week.

Wow, every time I think they can't go any lower and just have to start climbing soon, rates go down. Again. That probably has many of you wondering whether it's worth it to refinance your mortgage when it's probably already at an enviable rate by historical standards.

To help you answer this question, I came up with the Refinancing Rule of 5s.

Here it is:

Refinancing Rule of 5s:

1.Your new interest rate should be at least .5 percentage points lower than your current rate.

The old rule of thumb was that you should refinance if you could get a rate that was 1 to 2 points lower than your current one. Well, the rules have changed, because rates in recent years have been at historical lows, so a half point drop makes up a larger percentage of your existing rate.

2. You should add 5 years or less to the length of your loan. Reducing the years would be even better.

Many people refinance into the same type of loan they started with out of habit. That can be a money mistake. If you are several years into a 30-year mortgage, don't sign up for another one because the money you save with the lower interest rate you will lose by stretching out your payments over several more years. Solution? Say you have only 23 years left on your existing mortgage. Refinance into a 25-year loan so you are not adding more than five years or -- better yet -- refinance into a 20-year mortgage and pay it off even more aggressively.

3.You should be able to recover your closing costs in 5 years or less -- preferably much less.

Closing costs are the elephant in the room when you refinance. You've got to make sure the new, lower interest rate is worth it given the sometimes hefty fees you have to pay to close the loan. If you plan to sell the house before you have recovered the closing costs you must pay to refinance, that is the No. 1 deal breaker. To figure this out, all you do is divide the cost of closing by your monthly savings to see how long it's going to take for the new loan to pay for itself. I suggest the five-year cutoff for recouping closing costs simply because stuff happens, life changes and you want to know you are out from under those closing fees should you need to sell unexpectedly.