Should You Refinance? Break Even Test and Calculator

The simple formula is useful, but it isn't the whole decision

The classic refinance break even formula is:

True refinance costs divided by monthly savings = months to recover the costs.

If a refinance costs $5,000 and saves $200 per month, the simple break even period is 25 months.

That is a good first filter. It becomes misleading when the new loan changes the term, principal balance, points or mortgage insurance.

Step 1: calculate the payment savings on comparable debt

Compare principal and interest on the current loan with principal and interest on the proposed loan, then separately account for mortgage insurance and other loan related monthly charges.

Don't let property taxes or homeowner's insurance make one lender's quote look better. Those costs generally follow the property, not the lender.

The CFPB specifically recommends focusing on lender controlled costs when comparing Loan Estimates.

Step 2: identify true incremental costs

A useful break even calculation normally includes lender origination charges, discount points, appraisal, title and settlement charges, recording related charges and other expenses caused by doing the refinance.

Escrow deposits and prepaid interest require more care. They can increase cash needed at closing, but they're partly timing items. The old escrow balance may be refunded after the old mortgage is paid off.

Step 3: treat points and lender credits as pricing choices

One point equals 1% of the loan amount. Points generally buy a lower rate. Lender credits generally offset upfront costs in exchange for a higher rate.

Assume a $300,000 refinance is available at 6.75% with minimal points or at 6.375% with 1.25 points.

The principal and interest payments are about $1,946 and $1,872. The lower rate saves about $74 per month. But 1.25 points cost $3,750 before considering any other pricing differences.

Ignoring tax effects, it takes roughly 51 months just for the $74 monthly difference to recover $3,750. If you expect another refinance or sale in two years, the lower rate option can be the more expensive choice.

This example is illustrative, not a rate quote.

Step 4: test the term reset

A borrower with 24 years left on the current mortgage shouldn't compare that loan only with a new 30 year payment.

Ask the lender to show a 20-, 25- or other term that more closely matches the remaining schedule, or calculate the payment needed on the 30 year loan to preserve the old payoff date.

The goal is to isolate the benefit of the new rate from the benefit of stretching the debt.

Step 5: compare remaining balance at your exit date

Suppose the simple break even is 20 months and you expect to sell in five years. That sounds good.

Now calculate how much principal will remain on each loan after five years. A refinance that saves cash flow but leaves you owing $12,000 more at sale isn't equivalent to one that produces the same payment savings without adding debt.

For a serious comparison, use:

Total interest and true costs paid through the exit date + remaining principal balance.

You can also compare net worth directly by looking at the mortgage balance under each option at the same future date.

Step 6: include mortgage insurance changes

Eliminating private mortgage insurance can dramatically improve the refinance. Moving into a loan with new mortgage insurance obligations can move the answer the other way.

Use the full loan related payment, not just the note rate.

Step 7: run more than one holding period

Nobody knows exactly when they will sell or refinance again. Run at least three timeframes:

• short case,
• expected case,
• long case.

For example: two years, five years and ten years.

This is particularly important when deciding whether to pay points. The best pricing choice can change depending on the holding period.

How to compare two Loan Estimates correctly

Make sure the estimates use the same loan amount, same lock period, same loan type and similar timing. Rates change daily. Comparing a quote from Monday with a quote from Friday can tell you more about the bond market than about the lenders.

Focus on the rate, points, origination charges, lender credits, total loan costs and the five year comparison on page 3.

A refinance can make sense even without a short break even

You may be refinancing to remove ARM risk, shorten the loan, remove a coborrower where permitted, or solve a mortgage insurance issue.

In those cases, break even is still useful, but it isn't the only goal.

A refinance isn't automatically good because the rate is lower

The right question isn't, "Can I lower my rate?" It is, "Does replacing this mortgage improve my position over the time I expect to keep it?"

A refinance changes several things at once: interest rate, loan term, principal balance, closing costs, mortgage insurance, escrow funding and sometimes the type of risk you're carrying.

A useful analysis has to measure all of them.

Start with the reason for refinancing

Most refinances are trying to accomplish one of five goals:

• reduce the monthly payment,
• reduce the interest cost,
• shorten the payoff period,
• eliminate or change mortgage insurance,
• or change the risk structure, such as moving from an ARM to a fixed rate.

Cash out refinancing is a separate decision because you are also increasing debt to receive proceeds.

If you can't clearly state the objective, it is difficult to tell whether the refinance succeeds.

The simple break even calculation is only the first screen

Assume refinancing produces $180 per month in payment savings and the true incremental loan costs are $4,500. The simple break even period is 25 months.

That is useful. If you expect to sell in 12 months, the refinance is immediately suspect.

But the calculation is incomplete because two loans can have different principal balances and remaining terms.

The term reset trap can make a refinance look better than it is

Suppose you owe $350,000 at 7.25% with 25 years remaining. Principal and interest is about $2,530 per month.

A new $350,000 loan at 6.25% for 30 years has principal and interest of about $2,155. The payment falls roughly $375 per month.

That looks excellent until you notice the borrower added five years back to the amortization schedule.

A better comparison asks what happens if you continue paying close to the old $2,530 payment on the new loan. That shows whether the rate reduction itself creates value rather than giving the new loan credit for extending the debt.

Compare the loan balances at your expected exit date

If you think you'll sell in five years, calculate the remaining principal on both loans after five years. Add the closing costs paid to obtain the refinance and the interest paid over the period.

The CFPB's Loan Estimate includes a standardized five year comparison that can help borrowers compare mortgage offers. It isn't a complete personal financial model, but it is much more useful than staring only at the note rate.

Separate true costs from timing items

Closing disclosures contain several categories of cash outlay.

Lender fees, appraisal, title charges and discount points are generally real transaction costs. Prepaid interest and escrow deposits are different. They affect cash needed at closing but can partly represent timing shifts for expenses the homeowner would pay anyway. The old escrow account may also be refunded after payoff.

For break even analysis, don't count the same economic cost twice.

Points and lender credits can reverse the answer

Points are upfront charges paid in exchange for a lower rate. Lender credits generally reduce upfront costs in exchange for a higher rate.

Neither is automatically good or bad. The correct choice depends heavily on holding period.

If you expect to keep the mortgage for two years, paying substantial points may never recover. If you expect to keep it for 15 years, a lower rate may be worth a larger upfront cost.

Ask for at least two versions of the same loan: one near zero points and one with the proposed points or credits. Compare them over the same time horizon.

A payment reduction can still be valuable even without the lowest lifetime cost

Sometimes cash flow is the objective. A household may intentionally refinance into a longer term to create monthly breathing room during a temporary income change.

That can be a rational decision, but call it what it is: a cash flow tradeoff, not necessarily an interest saving strategy.

The same applies to moving from an ARM to a fixed rate. Paying slightly more today can be worth it to remove future payment uncertainty.

Mortgage insurance can be the hidden swing factor

A conventional refinance may eliminate private mortgage insurance if the new loan and valuation support it. FHA refinancing can change the mortgage insurance structure, but FHA premiums follow program rules rather than simply disappearing because you have equity.

Run the full housing payment, not just principal and interest.

The refinance checklist I would use

Before deciding, write down:

• current unpaid principal balance,
• current rate and remaining term,
• current principal and interest payment,
• current mortgage insurance,
• proposed loan amount,
• proposed rate and term,
• points and lender credits,
• lender and third party costs,
• expected monthly savings,
• expected time before sale or another refinance,
• and remaining loan balance at that exit date.

If the lender can't provide enough information to fill in that list, the quote isn't ready to be evaluated.

Bottom line

A refinance should improve a measurable objective over a realistic holding period.

The strongest analysis compares cost and remaining debt at the date you expect to exit the loan. That prevents a longer term, points, credits or escrow timing from disguising the true tradeoff.

Florida note

In Florida, a refinance usually triggers documentary stamp tax on the new note and intangible tax on the new mortgage. Add them to your break even math, not just the lender fees.