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How to Find the Breakeven on Your Refinance

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When you’re thinking about refinancing your mortgage, it’s easy to focus on the interest rate and how much you can save every month.

But you can’t forget about your closing costs. To make sure fees don’t overwhelm your savings, it’s especially important to calculate your breakeven, which measures how long it takes you to recoup your closing costs based on your monthly payment savings. The quicker the breakeven, the sooner you start saving money — and the more cost-effective your refinance is.

What is a good breakeven on a refinance? The answer depends on a variety of factors, including what type of refinance you are doing and the overall financial goals you’re trying to accomplish.

In this article, we’ll look at breakevens in many different scenarios. These include refinances that actually increase your payment but provide long term benefits that can save you hundreds of thousands of dollars in interest over the life of a loan.

We’ll cover:

What is a breakeven and why is it important?

When you’re shopping for a refinance, you will likely hear more about interest rates than you will about breakevens.

You might be offered an interest rate that’s lower than the one you currently have. But how does that translate to whether a refinance is cost-effective or not? That’s where the concept of the breakeven point comes in. The breakeven evaluates how long it will take for you to recoup the dollar investment you make in a refinance.

Your investment comes primarily in the form of closing costs. Your return then comes through monthly savings on your mortgage payment, an increase in equity due to home improvements, a reduction in the amount of interest you pay over the life of your loan — or a combination of all three.

Before you can determine your breakeven, you need to understand the different types of refinances. Each type affects how to calculate your breakeven.

Common types of mortgage refinances

There are four main ways people choose to refinance, each with its own combination of costs and benefits. Some are straightforward — interest rates have dropped, and homeowners want to lock in a lower rate. Some refinances, however, may not have an obvious benefit if you are just focused on monthly payment savings.

Rate and term refinance

The purpose of this type of refinance is to reduce your monthly payment by lowering your interest rate. Often called a rate and term refinance, it is the most common type during periods of falling interest rates.

Many lenders will offer streamlined options that include the ability to waive an appraisal or not require income documentation to qualify. The purpose of this refinance is to generate monthly savings with a lower interest rate and mortgage payment.

Cash-out refinance

When home prices rise, many homeowners take advantage of the extra equity in their homes by doing a cash-out refinance. The equity in your home is the difference between how much you owe and how much your home is worth. A cash-out refinance involves taking out more than the balance owed on your current loan. The first loan is paid off, with the rest coming to you in a lump sum of cash.

There are a number of reasons that you may want to take extra cash out, and each requires some extra analysis to determine your breakeven.

  • Debt consolidation. This is probably the most common. Using the extra cash to pay off  high interest rate credit card balances or car loans can be very cost effective.
  • Personal expenditures. You may want to take cash out to cover the cost of a college education, pay for a wedding, or subsidize the cost of a major medical expense that won’t be covered by insurance.
  • Home improvement. This provides you the opportunity to immediately recoup some of the costs of the refinance through an increase in your home’s value.

In these cases, you’ll want to consider the trade-offs between using a refinance and other forms of refinancing. With debt consolidation, you’ll factor in the benefit of eliminating high-interest-rate payments.

Term reduction refinance

This involves reducing the term of your mortgage from, say, a 30-year loan to a 15-year. Your monthly payment will go up, but you’ll be building equity in your home at a much more rapid pace and cutting out potentially tens of thousands of dollars worth of interest.

Calculating a breakeven on a term reduction is more challenging because you have to be able to look at the interest savings over the life of the loan to calculate your effective monthly interest savings.

How to calculate your breakeven

The calculating process can be straightforward. Or it get a bit more complicated, depending on the type of refinance you are doing.  We’ll dive into some of those nuances so you can be armed with the best breakeven calculations possible to determine the cost effectiveness of any refinance before you spend thousands of dollars on closing costs.

Step 1: Add up all your closing costs

Once you know what type of refinance fits your financial needs, you need to get some rate and fee quotes to determine your monthly savings and costs. Be sure to shop around and get multiple loan estimates from different lenders.

As you’re evaluating the closing costs, make sure you add up all of the lender fees and title fees (also known as non-recurring fees) in the closing cost details section of your loan estimate. Here’s an overview of what you’ll want to focus on.

  • Origination fee: These are fees that the lender charges for approving your loan. They will vary from lender to lender, and depends on the type of refinance you are doing.
  • Appraisal fee: Some refinances, especially cash-out refinances, will require an appraisal of your home to confirm the current value, as well as evaluate the condition of the home, considering any upgrades you have made since you purchased it. The costs of an appraisal range from $350 to over $750, depending on the type of loan you are taking out.
  • Credit report fee: Lenders will need to verify that your credit score meets the loan program’s minimum requirements. The cost can be anywhere from $40 to $85, depending on what type of credit report is required.
  • Tax service fee: This is used to ensure that your property taxes are paid on time as part of the set-up and verification of your escrow account.
  • Flood certification fee: This is charged to verify if your property is located in any flood plains that might require you to obtain flood insurance.
  • Title fees: Because you’ll be recording a new lien on your house and paying off an old one, you will incur title fees. The lender will require a title search on your property to confirm the status of your ownership. The title company will verify that your property taxes are current and that you have clear title to the property.

Don’t include recurring fees like homeowner’s insurance, property taxes and prepaid interest on your new loan. These amounts will affect the total amount of cash you need at closing, but are not taken into consideration when calculating your breakeven. That’s because they are ongoing costs you pay regardless of whether you refinance or not.

Step 2: Add up the life of loan benefits

Once you’ve totaled up the costs, you need to look at the benefits in your monthly payment and/or equity. In many refinances, you’ll focus on your monthly payment savings. But some refinances don’t involve lowering your interest rate or your payment — like cash-out refinances or term reduction refinances.

We’ll look at the basics of all of the potential benefits to make sure you’ve got a thorough picture of of how the refinance will affect your financial goals.

Payment benefits

If you are lowering your interest rate, the most obvious benefit is the money you save on your monthly payment. This is the most common benefit related to a “rate and term” refinance, which basically means you are lowering your interest rate while paying off the balance of your current, higher-interest-rate loan.

Interest savings benefit

This is a benefit you usually get by switching from a longer-term to a shorter-term loan. Your monthly payment might go up, but the total amount of interest you would pay would be much less. In addition, you would be paying off your loan faster, which means you’d be building more equity with each month’s payment.

Equity benefit

If you are refinancing to do home improvements, you may realize an increase in your home’s value. Although you won’t know exactly how much benefit you will get unless you sell the house, you can get an idea by using a cost-to-value estimator before you make a final decision on doing a cash-out refinance for home improvements.

Since home values fluctuate from year to year, you can’t really calculate the equity benefit as a monthly amount.  However, you should put it in the “plus” column, if you know other homes in your neighborhood are selling at higher prices with similar types of improvements you are doing.

Cost alternative benefit

This is usually applicable to a cash-out refinance for a home improvement or a special life event.  In the case of a home improvement, you’ll need to analyze how much you are saving by refinancing to pay for the improvements, instead of alternatives like a home improvement store credit card or personal loan.

The same is true if you are accessing credit for a major life event like a wedding or college tuition. You’ll want to compare other options, like a 401(k) loan, or some other type of financing option to determine how it would compare to the cost of the cash-out refinance.

However, you still have to do the equity cost calculation to see how much in lost equity you are giving away by taking the cash out from your home’s value.

Step 3: Subtract the life of loan costs

This is different from adding up your closing costs. This involves an analysis of the monthly costs, as well as how much equity you are using to complete your refinance in the case of a cash-out refinance.

Payment costs

The simplest example of a refinance payment costs would be if you currently have a 30-year fixed loan, but you want to switch to a 15-year fixed. In most cases, your monthly payment will increase substantially.

You’ll need to consider this when you complete your breakeven analysis. This also applies if you are refinancing to pay off an adjustable rate mortgage, or an interest-only loan. You’ll likely be trading a lower current payment, for a future higher payment.

Equity cost

This is a cost incurred when you do a cash-out refinance.  If you borrow an extra $50,000 to pay off some car loans and credit cards, you’re losing that equity and replacing it with debt.

Just like an equity increase, this can be a moving target and is hard to calculate.  If you borrow an extra $50,000 when you’re planning to move soon, then you could be putting yourself in a situation where you will make very little.

Since you lose equity when you do a cash-out refinance, you should reflect the cost in your breakeven by dividing the total amount of extra cash you borrowed by the term of your loan.  So if you borrow an extra $50,000 of cash, you would divide this by the term of your loan, which for a 30-year loan would be 360 months, for a monthly equity cost of $138.89.

Long-term interest cost

In a cash-out refinance, because you will be borrowing more money, it’s also important to calculate the total long-term interest cost.

You need to look at how much interest you would have paid over the life of your current loan versus the amount of interest you’ll pay over the life of your new loan to establish a good breakeven for the refinance.

If you need to do the cash-out refinance because you’re feeling the strain of maxed out credit cards or high monthly debt obligation, this calculation may not carry much weight, but it’s still something to consider when determining the short and long term benefits of the refinance.

Step 4: Divide the net monthly savings benefit by the term of your loan

Once you have all of the payment and equity savings and cost figured totaled up you’ll want to make sure you have them reflected in monthly terms. This is important to make sure the final calculation is correct.

For example, if you are taking out a 30-year mortgage, you would divide your long-term interest cost or equity cost by 360 months.

Step 5: Divide the total closing costs by the net monthly savings benefit

The final step is to divide the amount of closing costs you are paying by your net equity and payment savings. That’s your breakeven, in months.

We’ll put these steps to the test on an actual refinance to see how the numbers roll out on a cash-out refinance, and a term reduction refinance. This way you can see how to analyze a refinance that not only lowers your payment, but one that increases your payment but increases your equity faster.

How a cash-out refinance breakeven analysis works

In this example, we’ll assume you have a house worth $250,000, and a $150,000 first mortgage at a current rate of 5%.

We’ll assume you can get a new mortgage of $200,000 at a rate of 4.25%, with the proceeds used to pay off a $10,000 car loan with a $450 per month payment and $30,000 of revolving credit card debt with a minimum payment of $500 per month.

Now we’ll work through the steps.

1) Start with your closing costs

We’ll also assume the closing costs are $2,500.

2) Calculate the monthly costs savings and equity increase

At 5% on a $150,000 loan, you are paying $805.23 per month in principal and interest. You’ll need to add the $450 per month car payment and the $500 per month credit cards to figure out what your total monthly payments are before the refinance.

In the case, the total is $1,755.23 per month.

There will be no increase in equity or any long-term interest savings, since we are using $50,000 of equity and adding interest to the loan because through a higher loan amount.

3) Calculate the monthly payment and equity costs

The monthly payment in this example would go up to $983.88 per month, which is an increase of $178.65. Since this is an increase in the costs, we would input this as an increase in payment.

As for equity, let’s assume you plan to keep the house for the full 30 years. We divide the $50,000 in lost equity by 360 months of payments, for an equity effect of $138.89 per month.

4) Subtract the monthly payment and equity costs, from the monthly payment and equity savings

Now that we’ve calculated the monthly payment savings and equity benefits and costs, we can subtract the savings amounts from the costs, to get your net saving and equity figure.

Our savings are the $950 per month from paying off the credit cards and auto loan. From that, we subtract the $178.65 in increased monthly payment and the $138.89 in equity costs. That gives us a net savings of $632.46 per month.

5) Divide your closing costs by net monthly savings figure

The final step takes your total closing costs and divides them by the net savings and equity to get your monthly breakeven.

We divide the $2,500 in closing costs by the $632.46 in net monthly savings. That gives us a breakeven point of 3.95 months.

What is a good breakeven?

There is no general rule of thumb for what is considered a good breakeven.  The sooner you can realize savings, the more cost effective the refinance will be.

However, you should always try to establish a breakeven that is consistent with how long you plan to keep your home. There is simply no benefit to refinancing a home if you won’t recoup the costs before you sell the home.

If you plan to keep the property for the long haul, it’s important to look at the long-term costs — such as the overall interest and equity you are using for the refinance — as well as the short-term savings.

The most obvious benefits are always realized with a simple rate reduction refinance. Cash-out or term-reduction refinances require a more time-intensive analysis.

Final thoughts

You shouldn’t have to do all the heavy lifting on a breakeven calculation yourself.  Your loan officer should be ready, willing and able to provide a cost benefit analysis for any refinance.

If not, you may need to shop around for someone willing to quote more than just rates and fees. A good loan offer should go the extra mile to make sure you’re getting the benefit possible for your refinance dollar.

 

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