Mortgage Refinance, What’s Your Break Even Period?

***Disclaimer: The opinions expressed throughout this post are my own and not those of any company I work for. This post is for informational purposes only and is not a solicitation for any business. Nothing in this post is a recommendation to take or refrain from any action in regards to financial planning, investments, taxes, insurance, estate planning or anything else. Please consult a qualified professional before making any decisions for your personal situation.***

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With interest rates near all-time lows, I’ve been hearing the word “refinance” more and more often. In fact, one report shows that “refinance lending was up more than 60% from Q1 2020 and more than 200% from the same time last year.” Clearly refinancing your mortgage is a trendy financial topic. 

There are many reasons why you may choose to refinance your mortgage:

• You have an adjustable-rate mortgage (ARM) and want to switch to a fixed-rate mortgage (FRM),
• You want to take out some equity you have in your home (a “cash-out refi”),
• You want to remove private mortgage insurance (PMI),
• You want to extend your mortgage term, or
• You want to take advantage of lower interest rates.

This article will focus solely on the last bullet above. You want to capitalize on today’s low-rate environment and hopefully lower your own interest rate on your mortgage. This can lower your monthly payment and potentially save you lots of interest over the lifetime of your loan.

However, refinancing your mortgage costs money. This is why you’ll often hear people refer to a “break even point,” which is an estimate of how long it will take you to recoup the upfront costs of refinancing from the interest rate savings. Usually, the shorter the breakeven period, the more refinancing may make sense.

Unfortunately, many people incorrectly calculate their break even period. So this article will use a hypothetical scenario to walk step-by-step through the method I use. Let’s get to it.

Step 1 - Buy a House

If you are thinking about refinancing your mortgage, it means you must already have an existing mortgage. For our hypothetical scenario, let’s say we have a homeowner named Ally. About 2 years ago (as of the date of me writing this), Ally bought a home and took out a $500,000, 30-year, fixed-rate mortgage. In September of 2018, according to the Federal Reserve Bank of St. Louis, rates for this type of mortgage were ~4.65% (see image below).

Source: Federal Reserve Bank of St. Louis

Using a simple mortgage amortization calculator and a spreadsheet, I can see that Ally’s monthly mortgage payment (principal + interest) is $2,578.18, and I can graph her projected mortgage balance over time (see image below).

This is the baseline scenario. If Ally is considering refinancing to lower her interest rate, she should likely only do so if it will make her better off financially than this baseline scenario.

Step 2 - Consider Refinancing

Fast forward 2 years to today (September, 2020), and mortgage rates have gone down to ~2.86% (see image below). That is 1.79% lower than Ally’s current rate!

Source: Federal Reserve Bank of St. Louis

At this time, after making payments for 2 years, Ally has $483,918.50 remaining on her mortgage. If Ally were to refinance to a new 30-year mortgage, her new monthly payment (principal + interest) would only be $2,003.86. That is $574.32 less than her current monthly payment.

However, this is not a true apples-to-apples comparison. The reason is because, after already having her mortgage for 2 years, Ally would be taking out a new 30-year mortgage. That means she would extend the time it will take to pay off her house by 2 years (see image below).

Yes, some of the $574.32 in monthly savings comes from lower interest rates. But some of the savings is also coming from spreading her mortgage payoff over a longer time horizon! This may not be what Ally wants, and it certainly isn’t an apples-to-apples comparison.

To be more accurate, we should instead compare the two mortgages using the same monthly payment of $2,578.18. This will allow us to isolate the impact of a lower interest rate from the impact of increasing the mortgage term.

Since most mortgage companies only offer mortgages of specific term lengths (10-year, 15-year, 30-year, etc.), Ally likely will need to take out a new 30-year mortgage and simply make a larger-than-necessary payment each month. Many companies will let you do this without any prepayment penalties. So her new monthly payment will be $2,578.18 ($2,003.86 required payment + $574.32 optional extra payment). 

If Ally does this, she will end up paying her mortgage off in July, 2041. That is over 7 years earlier than originally planned (see image below). And she will be able to do this all while still making her original monthly payment. This is simply because Ally was able to refinance to a lower interest rate.

That sounds great, and it appears that refinancing likely makes sense for Ally. But not so fast. As the saying goes, “there is no such thing as a free lunch.” Refinancing your mortgage is no exception. There is a little something called closing costs that also must be factored into our analysis.

Step 3 - Factor in Closing Costs

Refinancing your mortgage comes with various fees. Together these fees are called closing costs and may include appraisal fees, title fees, notary fees, etc. These fees can add up to thousands of dollars, which means they can have a big impact on whether or not refinancing makes sense for you.

An estimate of your closing costs can be found on your Loan Estimate. Your Loan Estimate might be a bit intimidating with lots of different sections, so this Sample Loan Estimate put out by the Consumer Financial Protection Bureau (CFPB) may be useful. In particular I usually ignore most of the prepaids and escrow amounts, as those are not actually part of the loan costs.

For our hypothetical scenario, let’s assume that Ally’s applicable closing costs on her loan are $5,000. If she has $5,000 available, she has 2 choices:

1. Pay the $5,000 in closing costs and refinance her mortgage, or
2. Make a one-time extra payment of $5,000 in September, 2020 towards her existing mortgage.

Let’s compare both of these choices to see which may make more sense for Ally (see screenshot below). If she uses her $5,000 to make a one-time extra payment to her existing mortgage, she will cut 7 months off her mortgage and have it paid off in February, 2048. Not too bad. But as we already looked at, refinancing means Ally will pay off her mortgage in July, 2041.

Based on this comparison, refinancing still appears to be the better choice. But there is still 1 missing piece Ally should analyze before deciding to go ahead and refinance. That missing piece is her break even period.

Step 4 - Calculate Break Even Period

If Ally pays the $5,000 in closing costs and refinances, she will pay her mortgage off ~6.5 years earlier than instead using the $5,000 to make an extra one-time payment to her existing mortgage. Based on that, refinancing seems to be the better option.

However, that analysis assumes Ally will stay in her home until the mortgage is paid off, which will be decades. What if Ally moves out of her current home before then? That is where the break even period comes in.

The refinancing option may be better in the long run, but it will take time to recoup the $5,000 in upfront costs. How much time? The table below shows that initially, putting the $5,000 towards her existing mortgage puts Ally ahead. It isn’t until May, 2021 that the lower interest rate of refinancing “catches up” to sticking with the original loan. Thus, in Ally’s case, refinancing has an 8-month break even period (note that each person’s break even period will be different depending on their circumstances).

If Ally plans on staying in her current home for 8 months or more, then refinancing appears to make financial sense. If she does not plan to stay put for 8 months, then Ally should consider sticking with her existing mortgage.

Bonus Step - Can’t Afford Closing Costs

Using the above break even analysis, if Ally plans to stay in her current home for 8 months or more, then it appears refinancing makes sense. But that requires Ally to pay the $5,000 of closing costs up front. What if Ally can’t afford that?

Not to worry. Ally could consider doing a “no-cost refinance” where the lender agrees to cover your closing costs. But remember, there is no free lunch. Usually this will result in either a slightly higher interest rate, or increasing the loan amount. 

For example, Ally’s current mortgage has $483,918.50 remaining on it. If she wanted to do a no-cost refinance, she could roll up the $5,000 in closing costs into her new loan. This would mean her new mortgage would actually be $488,918.50 (the remaining $483,918.50 + the $5,000 in closing costs). You’ll see that initially this means Ally is actually increasing her debt! But the lower interest rate may eventually make up for this. Again, Ally must conduct a break even analysis to see if this makes sense for her situation, but I’ll save that for another article.

Wrapping It All Up

There are many reasons to consider refinancing your mortgage. One such reason is that interest rates have dropped. In that case, refinancing may save you money. But when deciding if it makes sense, there are many things to consider:

• Are you comparing the same monthly payment or not?
• Are you factoring in closing costs?
• Are you factoring in how long you plan to stay in your home?

All of these are important inputs and are things I use when calculating a break even period for refinancing. 

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***Disclaimer: The opinions expressed throughout this post are my own and not those of any company I work for. This post is for informational purposes only and is not a solicitation for any business. Nothing in this post is a recommendation to take or refrain from any action in regards to financial planning, investments, taxes, insurance, estate planning or anything else. Please consult a qualified professional before making any decisions for your personal situation.***