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Have you ever heard this one? “It’s not worth refinancing unless you are going to drop your rate by 2%”. It is generally preceded by “my parents told me”…
I cannot tell you how many times I have heard that in the past 13 years. So, where did the notion of the 2% threshold to refinance come from? It is driven by the average sales price of a new home. Let’s do the math.
If we take a historical look back at the average new home sales price in the United States, the price of a home in January of 1976 was $72,400. Fast forward to January of 2016 and it was $363,400. The average loan size of a mortgage is going to dictate how a change in interest rate will affect the viability of a refinance scenario. Let’s do the math!
I will assume each home was financed using a 20% down payment, leaving their loan amounts at 80% of the value ($57,920 & $290,720 respectively). Now, applying the average 30 year fixed interest rate for that period of time (January 1976: 9.02% vs. January 2016: 3.875%) we can determine how the mortgage amount will dictate our threshold of interest rate change:
1976: $57,920 @ 9.02% = $466.87 (principal & interest)
If we reduce the 1976 interest rate by 2% (7.02%), we have a new payment of:
$57,920 @ 7.02% = $386.12
Creating a savings of $80.75
In order to save the same $80 in principal and interest payments in 2016:
2016: $290,720 @ 3.875% = $1,367.07 (principal & interest)
If we reduce the interest rate by .5% (3.375%) we have a new payment of:
$290,720 @ 3.375% interest = $1,285.26
A difference of $81.81
Now, refinancing your mortgage to save $81 per month may or may not be worth it to you personally. The point of this exercise is that you do not need to wait and hope that rates fall by 2% in order for it to make sense to refinance.
You should always seek out a residential mortgage lender to help you calculate the monthly savings while taking into account any and all cost associated with a new loan. This will ensure you have the proper information to make an informed decision on one of the biggest financial decisions you will make in a lifetime.
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