Refinancing: Three Ways to Measure Whether It Pays Off

A lender quotes a lower payment and tells you how many months it will take to "break even." Is that enough to decide whether a refinance pays off? Usually it answers one question, how long until the closing costs are covered, and leaves two others open: where the savings came from, and what the loan balance looks like afterward.

Key takeaways

• A simple break-even divides closing costs by the monthly savings, so it shows how long it takes to recover the costs and nothing more.
• Part of a lower payment can come from a longer loan term rather than a lower rate, so comparing against the same remaining term separates the two.
• In the hypothetical example, the new loan carries a slightly higher balance after five years even though the household has paid about $9,900 less.
• Rolling closing costs into the new loan or accepting a higher rate to cover them can lower the upfront bill while raising the long-run cost.
• How long a household expects to stay in the home affects every one of these comparisons.

What a refinance replaces

The Consumer Financial Protection Bureau describes a mortgage refinance as taking out a new loan to pay off and replace your old one. It adds that a refinance usually involves closing costs. The agency's refinancing handout also points out that a household can go through many of the same steps, and pay many of the same costs, as when it first got the mortgage.

That is why the comparison needs more than the payment. The new loan comes with its own rate, its own term and its own price tag.

Comparison one: how long to recover the costs

This is the familiar break-even. Divide the closing costs by the monthly savings.

For example, a hypothetical household owes $300,000 with 27 years left at 7.0 percent, a payment of about $2,063. A lender offers a new 30-year loan at 6.0 percent for $6,000 in closing costs, paid in cash. The new payment is about $1,799, a saving of roughly $265 a month. Dividing $6,000 by $265 gives about 23 months.

That figure is useful. It tells the household how long it needs to stay for the monthly saving to cover the fees. It does not say how much of the saving is real.

Comparison two: what the same term would cost

In the example, the new loan restarts a 30-year clock while the old one had 27 years left. Part of the lower payment comes from spreading the balance over three more years.

To separate the effects, compare against a loan at 6.0 percent over the same 27 years. That payment is about $1,872, a saving of roughly $191 a month. The break-even stretches to about 31 months. In other words, around $74 of the monthly saving comes from the longer term rather than the lower rate.

Extra years are not automatically bad, since some households want a lower required payment. But they have a cost. In this example, after 27 years the new loan would still carry a balance of about $59,100, with three more years of payments to go.

Comparison three: payments made and balance owed

A lower payment does not mean less is owed. Consider where each path stands after five years, counting the $6,000 as part of what the new loan cost.

• Keep the current loan: about $123,800 paid in total, and about $277,600 still owed. Together that is roughly $401,400.
• Refinance to the 30-year loan: about $113,900 paid including the closing costs, and about $279,200 still owed. Together that is roughly $393,100.

The refinanced household has paid about $9,900 less but owes about $1,600 more. Adding the two figures together, the new path comes out roughly $8,300 ahead. In this example the two paths cross over at around the two-year mark.

This view leaves out taxes, changes to insurance or escrow, and what the household does with the monthly saving. It is a way to ask whether the costs and the slower paydown are offset by lower interest, not a forecast.

When the numbers look different

Smaller changes can alter the answer. Suppose the starting rate were 6.5 percent and the new rate 6.0 percent, with the same $6,000 in costs. The 30-year payment would drop by about $168 a month, a break-even near 36 months. Against the same 27-year term, the saving would be about $95 a month, and the break-even would be around 63 months. After five years the new loan would also carry a higher balance than the old one, about $279,200 compared with about $275,900.

The way costs are paid matters too. The CFPB explains that a loan advertised as having no closing costs generally means a higher interest rate or closing costs rolled into the loan balance. Rolling in the $6,000 in the first example makes a $306,000 loan with a payment near $1,835. The monthly saving shrinks to roughly $229, and the balance after five years is about $284,700, compared with $277,600 on the current loan.

Finally, the CFPB says that if you know you will move in the next few years, you might not have time to recoup the cost of refinancing. It also says to check for a prepayment penalty on the current loan.

Questions to put to the lender

1. What are the total closing costs, and how much is paid in cash versus added to the loan?
2. What would the payment be at the new rate over my current remaining term?
3. How much will I owe in five and ten years under each loan?
4. Does my current loan carry a prepayment penalty?
5. How long do I realistically expect to keep this home?

The Loan Estimate that a lender provides shows the features of the loan and its total dollar cost, which makes it a good place to start comparing.

Common questions

How do you calculate the break-even point on a mortgage refinance?

Divide the total closing costs by the amount the monthly payment drops. The result is the number of months to recover the costs. It is only a starting point, because it ignores the loan term, the balance and how long you will stay.

Is a lower monthly payment enough reason to refinance?

Not by itself. A payment can fall because the rate is lower, because the term is longer, or both. The Consumer Financial Protection Bureau notes that refinancing usually involves tradeoffs and closing costs, so the full cost of the new loan matters too.

What if I plan to move in a few years?

The CFPB says that if you know you will move in the next few years, you might not have time to recoup the cost of refinancing. A longer break-even period carries more risk for a shorter stay.

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