Is Now the Time to Refinance? Break-Even as Important as Low Rates

See How the Break-Even Point and Interest Costs Affect You

Approved Mortgage Refinance Application Form with pen, calculato
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Refinancing your mortgage can be appealing, especially when you can secure a lower rate at a time when they are historically low. You have the potential to lower your monthly payments, pay off your mortgage sooner, and maybe even cash out some of the equity in your home. But closing costs and fees can quickly eat into any savings you might hope for, leaving you right where you started—or worse.

There are some situations when refinancing your home loan definitely makes sense. A bit of math can help you identify those opportunities.

Know Your Break-Even Point

One tool to help evaluate refinancing is a break-even point. This analysis allows you to figure out how long it takes to recoup the costs you’ll pay to refinance. For example, assume you pay $2,000 in closing costs and fees for a new loan, and your new payment will be $100 per month less than you pay now. In this scenario, it takes 20 months to break even (to calculate, take $2,000 in costs divided by $100 in monthly savings). After that, you come out ahead by $100 each month.

To calculate a break-even point, divide your monthly savings into the costs required to refinance. A written formula would look like this: Number of months to break even = Closing costs / Decrease in monthly payments

For refinancing to make sense, your break-even point needs to be relatively soon. A shorter period enables you to reap the benefits for more years before you sell or refinance again. This calculation is especially useful if you plan on moving, because you already have an idea of when you might sell your home.

Closing costs for a refinance are often around 3% and 6% of the loan's principal. Keep in mind that costs and fees may vary somewhat from lender to lender and even from loan to loan, so take that into account when doing your calculations.

Switching Between an ARM and a Fixed-Rate Mortgage?

One of the times it may make sense to get into a different mortgage is to switch between an adjustable-rate mortgage (ARM) and a fixed-rate one. ARMs can eventually end up with higher interest rates than fixed-rate mortgages, even if an ARM starts out lower. Those low rates can lead to borrowers getting caught by surprise later when their monthly payments go up along with their rates. Refinancing an ARM to a fixed-rate 15- or 30-year mortgage can eliminate uncertainty surrounding variable rates. It’s ideal to make this switch when rates are low.

On the other hand, when mortgage rates are plummeting and you expect that to continue, it might make sense to switch from a fixed-rate mortgage with a high interest rate to an ARM that takes advantage of lower rates. A refinance of this sort is best suited to homeowners who can absorb higher monthly payments if rates bounce back up again.

It’s impossible to predict the future, so there is always uncertainty when choosing between a fixed-rate loan and an ARM. If you go with an ARM, be sure you can afford higher payments, just in case.

A Shorter Mortgage Term

Refinancing may allow you to pay off your home sooner, shaving years of payments off your loan. You can also take advantage of lower overall interest costs of a shorter-term loan. 

A mortgage spread over 30 years will cost more in interest than one spread over 15 years. For example, $200,000 borrowed over 30 years at 4% will cost $143,739 in interest alone. The same mortgage over 15 years will cost $66,288 in interest. So, if you’re looking to minimize interest costs and get out of debt sooner, refinancing to a shorter term makes sense. Plus, shorter-term loans tend to have lower rates than long-term loans. 

Get a Better Rate

Mortgage rates fluctuate constantly. The rate you get depends on numerous factors, including your credit score, economic policy, and the property you own. If the rate you qualified for when you originally bought your home is significantly higher than what you could obtain today, you might save money by refinancing.

A better rate is always nice, but make sure you come out ahead after paying closing costs. A few ways to do that include:

  • Running a break-even analysis, as described above
  • Looking at total lifetime income costs (see below)

When to Be Cautious About Refinancing

In some cases, it's not a good idea to refinance. For example, sometimes your total interest costs will increase—even if your monthly payment decreases. That’s especially true if your new loan has a longer term, like when you switch from a 15-year loan to a 30-year mortgage.

An amortization table can help illustrate how this happens. Each time you make a monthly payment, part of your payment goes toward the principal you borrowed, and part of it is your interest cost. In the early years of your loan, most of each payment goes toward interest, barely making a dent in the principal.

If you keep your old loan, more and more of each payment goes toward reducing the loan balance over time. But if you scrap your old loan for a new one, you go back to the beginning of the amortization process, and back to those early payments that are mostly interest costs. If you had a 30-year mortgage and refinanced after 10 years to another 30-year mortgage, it's like resetting the clock—you’ll make payments on your home for a total of 40 years.

Look at the big picture before you refinance. You may pay a few hundred dollars less each month if you refinance, but it can cost you tens of thousands of dollars more in interest over your lifetime.