Mortgage Q & A: Breaking Even on Refinancing

Q: I need to refinance my mortgage. A friend told me to make sure I'll keep this house long enough to break even on the refinance. What does that mean and how do I know how long it will take to "break even?"

A: Your friend is referring to the time it takes for the savings you get by refinancing to cover the cost of your mortgage refinance. There are two popular ways to calculate this time frame.

1. "Savings" generated by a lower payment. This is the most inaccurate breakeven calculation. Sadly, it's also the one most widely used. If your refinance costs $1,000, for example, and gets you a payment that's $35 a month lower, your breakeven is $1,000 / $35, or 28.5 months. The reason this is a poor measure is that the difference in payment doesn't necessarily represent your savings. If you refinanced a 30-year mortgage at 6.5 percent to a 15-year loan at 3.0 percent, obviously there is savings -- but because the 15-year payment is higher, this calculation won't find it.

The second reason this calculation is highly-flawed is that a payment can be lowered by merely stretching out the repayment of your loan without even reducing the interest rate. Taking the remaining balance on a 30-year loan (say, you have 25 years left on your loan) and refinancing it to a new 30-year term, even at the same rate, gets you a lower payment. Yet clearly there is no savings being created.

2. A better calculation is more complex. You compare the old loan and the new loan by looking at their amortization schedules. Say, for example, that in the first month, your refinance loan has an interest charge of $700 and $300 goes to the principal. Your old loan has an interest cost of $900 and $450 going toward the principal. So the savings for that months is ($900-$700), which is the difference in interest costs, minus ($450-$300), because the old loan is paying down the principal balance faster. So the savings from that month is $200-$150, or $50. You subtract that savings from your refinancing cost (if refi costs are $1,000, you reduce it by $50 and it's now $950). You repeat the calculation (the figures will be different each time) until the refi cost balance is reduced to zero. That month is your break-even point.

Yes, it's complicated, but fortunately, we've done the work for you at LendingTree. Simply put your loan parameters into our refinance break even calculator and you'll get your answers.
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