Refinancing a home is a popular way to save money, but it is often the case that you have to spend money to make money. The upfront closing costs involved can mean it will take several months before you break even as a result of refinancing.
This makes the break-even point a crucial part of the refinancing decision. However, like beauty, the break-even point for refinancing a home is in the eye of the beholder. There are various ways of looking at break-even, and each has some validity depending on your perspective.
Different Views of Break-even
Broadly speaking, the break-even point on refinancing a home is when your monthly savings add up to the point that they offset the upfront costs (fees, points, etc.) of refinancing. Measuring how long it takes for refinancing to pay off is important, because the longer it takes, the more uncertainty enters the picture. For example, if you end up selling your home in a couple years, you may never reach your break-even point. Or, if you have an adjustable-rate mortgage, a change in rates could completely alter the break-even dynamics.
Refinance calculators will often show you a break-even point, but it is important to know how they are defining break-even. Here are four different ways of looking at it:
- Break-even based on total payments. This is a simple -- but potentially deceptive -- way of looking at the break-even point. If it costs you $2,000 to refinance and you end up saving $200 a month, you will break even in 10 months. However, if you lowered your payments by lengthening out the remaining term of your mortgage, it may end up being more expensive in the long run because of the extra years' worth of interest you have tacked onto the loan. So, break-even based on total payments should only be of significance to you if your primary goal in refinancing is to take some pressure off your budget by lowering your monthly payments, even if it means paying more over the course of the loan. In that case, your best course may be to either finance the upfront costs (i.e., include them in the principal of the new loan, if possible) or opt for a loan with a slightly higher interest rate in exchange for lower upfront costs.
- Break-even based on interest payments. Since simply spreading principal payments over a longer repayment period does not represent true savings over the course of the loan, another method of calculating the break-even point is to focus solely on the interest portion of your payments. If you have refinanced to lower your interest rate, this method will measure the trade-off between the savings this produces and what you had to pay upfront to refinance. However, this method does not account for one very important aspect of mortgage interest -- federal tax deductibility.
- Break-even based on tax-adjusted interest. If you are in a position to deduct the interest on your mortgage, your after-tax savings from refinancing will be effectively reduced by your tax rate. This is because any interest you pay on a mortgage does not cost as much as it appears if you are able to deduct that interest on your taxes. This reduction in the savings from refinancing will lengthen the break-even period.
- Break-even compared to prepayment. If refinancing is going to cost you money upfront, an alternative is to put that money into prepaying some of your existing mortgage. This is a valid option as long as there are no applicable restrictions or costs for prepaying your current loan. Taking an immediate bite out of the principal you owe will lower the interest payments on your existing loan, thus reducing the potential savings from refinancing. This will result in a longer break-even period than comparing refinanced interest payments with your current interest payment schedule.
Which version of break-even is most important to you? It depends on your circumstances and what you want to accomplish by refinancing a home. It may be that looking at refinancing from all these angles will give you the best view of whether it makes sense for you. Fortunately, that's easy to do with LendingTree's Refinance Break-even Calculator. It allows you to see all four calculations, how much your monthly payment will change, how long your new repayment will take, and how much you'll save (or not) over the life of your mortgage.