The break-even point is when the savings from your refinance have added up to equal the refinance cost. This number can impact whether or not you refinance at all. If you sell your house before the break-even point, you will lose money. That might not be the end of the world if selling your home becomes necessary; however, most people will choose not to refinance if they plan on selling in the next couple of years. In general, you should recoup your closing costs in two to four years.
There are two ways to reach the break-even point after you refinance.
- Reduced monthly payments
- Accelerated paydown of principal
Reduced Monthly Payments
Getting a reduced monthly payment from the refinance is the simplest way to calculate your break-even point. Add up the total cost of the refinance and associated fees then divide by the number of dollars you save every month.
For instance: if your refinance cost you $10,000 while reducing your monthly payments by $250 every month, the calculation would be: $10,000/$250= 40 months until the break-even point.
Accelerated Paydown of Principal
The accelerated paydown of your principal can be just as powerful to get you to the break-even point as having a lower monthly payment. The tricky part is going through the process of figuring it out.
Every month when you pay your mortgage, the payment is split between interest and principal. In the early years, a more significant portion of the payment goes towards interest. But when you refinance to a lower interest rate and a shorter-term length, you can begin to tip the scale resulting in a lower portion towards interest and a greater portion towards the principal. Interest will still be front-loaded but not as heavy because it’s based on your reduced rate and term.
Let’s run through the total monthly payment amount and how it is broken down between principal and interest with an example of a refinance offer. We will start with the original loan then consider a refinance three years after the original loan, data based on an amortization schedule.
Original Loan: $335,000 and 30-year fixed 4.25%
Monthly payment: $1,648
Principal portion 3 years in: $524
Interest portion 3 years in: $1,123
After three years, the principal balance of the loan is down from $335,000 to $316,000. If you roll closing costs of $9,500 into that the new loan, the total would be $325,500.
New Loan: $325,500 and 25-year at 3.25%
Monthly Payment: $1,586
In comparison, the monthly payment goes from $1,648 to $1,586, which is a savings of $62 every month. That isn’t very much, but the key here is that the amount of money towards the principal increased by $180; this means you are building equity at an accelerated rate, and you will reach your break-even point quicker because the net effect is the same. Whether it’s extra money in your bank account or extra money in your home’s equity, you are saving money from the refinance.
The break-even point for this example is ($9,500) / ($61.79 + $180.47) = 39 months
The break-even point is used to determine the length of time it will take to make up for the cost of the refinance. However, don’t let the break-even point be the deciding factor of which refinance offer you choose. It is best to calculate the value of your different refinance options and the net financial impact they will have on you.