Refinancing - Breakeven and More

Approved Mortgage Refinance Application Form with pen, calculato
••• Courtney Keating / Getty Images

It’s hard to know whether or not you should refinance. You have to make some assumptions and have to do a little bit of math, and even then you probably won’t get a cut and dry answer. However, you can improve your chances by understanding a few concepts like breakeven and amortization.

Rules of Thumb

The traditional rule of thumb (which you should use with sparingly) for figuring out when to refinance is a basic breakeven analysis. This process allows you to figure out how long it will take to recuperate the closing costs you’ll have to pay to refinance. For example, assume you’ll pay $2,000 to refinance and your payment will be reduced by $100 per month. In this scenario, you’ll start saving money after 20 months.

Using this rule of thumb, you may decide that you should refinance if you’ll keep your loan for at least 20 months -- after that, you’re ahead by $100 per month. Most people who use this approach suggest that it makes sense to refinance if your breakeven point is within two years or so, and that’s not terrible advice. This method oversimplifies things, and it’s worth your while to get a better understanding of your loan before making a big decision. After all, this is probably the largest loan you’ll ever deal with.

Why Refinance

Start with the basics: why should you refinance? It only makes sense if you’ll end up saving money or solving a problem. An example of a problem solution is that you may want to get out of an adjustable rate mortgage (ARM); refinancing into a fixed rate mortgage means you’ll always know what your monthly payment will be.

Saving money means different things to different people. A simple way of thinking about saving is to consider cash flow: how much do you have to part with, and how much will you save? The breakeven analysis rule of thumb above considers cash flow, and cash flow is important.

You might end up spending more even if it feels like you’re spending less. Cash flow is only one factor. Your lifetime interest costs are another important factor. That is, the total amount that you pay the bank over the life of your loan should be part of the equation. In some cases, your total interest costs increase when you refinance -- even if your monthly payment decreases. This is especially true when you refinance into a longer term loan (like a 30-year mortgage).

When you make monthly payments, part of your payment repays the money you borrowed, and part of it is your interest cost. To understand this in greater detail, learn how amortization works. When you refinance, you get a brand new loan, and you re-start the amortization process. Most of your payment in the early years goes towards interest -- it doesn’t make a large dent in your loan balance.

If you keep your old loan, more and more of each payment goes towards reducing the loan balance. If you scrap your old loan for a new one, you’ll pay a lot of interest before you get back to the business of paying off the loan balance. The tradeoff is that you get to enjoy lower monthly payments today.

Another way of putting it: you can spend a few hundred dollars less each month if you refinance, but it may cost you tens of thousands of dollars over your lifetime. Is it worth it? Only you can decide.