The break-even point is the point at which you actually start saving money when you refinance a mortgage after offsetting the total closing costs of the new mortgage loan. It refers to the length of time it takes for a mortgage refinancing to pay for itself. It is worthwhile to refinance your home if you will stay in it long after the break-even point.
How to Calculate the Break-Even Point
The break-even point determines whether it makes sense for you to refinance a mortgage. It is calculated using this formula: Break-even point = Total closing costs ÷ Monthly savings
Closing Costs:
- Are the fees charged by the lending financial institution when closing a mortgage deal?
- Usually range between 2% and 4% of the property price for the borrower.
- Include title insurance premiums, loan origination, title search fees and appraisal.
These costs differ in each state, but they are rising in general. According to Bankrate’s 2017 Closing Costs Survey, for a $200,000 mortgage loan, the third-party and loan origination fees cost around $2,084.
Subtracting your new monthly mortgage payment when you refinance a mortgage from your initial monthly mortgage payment will give your monthly savings. For example, if your new monthly mortgage payment is $850 and your initial monthly mortgage payment is $950, your monthly savings are $100.
When you stay in your home after the break-even point, it becomes worthwhile to refinance your mortgage. For example:
- You incur total closing costs of $3500 when you refinance a mortgage
- Your monthly savings are $100
- Break-even point = Total closing costs ÷ Monthly savings = $3500 / $100 = 35 months
This means you need to stay in your home for at least 35 months after refinancing to start making savings.
How Long you Should Refinance a Mortgage for
The above formula does not compute the total savings through the duration of the refinanced mortgage loan. Taking a 30-year term loan when you refinance a mortgage can cost more at the end of the loan payments.
For example:
- Imagine you have a mortgage loan of $186,000 at 5% for 20 years and you obtain an offer after 10 years to refinance it at 4%.
- Let’s assume you were paying $998 monthly for 10 years.
- If you don’t take the refinancing, your total payments will be $239,520 over 20 years.
- With a refinancing, you are to pay $697 monthly for a 30-year term mortgage or $885 monthly for a 20-year term mortgage.
Calculating the total payments:
- For 30-year term: $697 x 360 months = $250,920
- For 20-year term: $885 x 240 months = $212,400
As shown, the 30-year term refinancing costs more than the initial mortgage while the 20-year term refinancing costs less.
How to Avoid Closing Costs
The closing costs can be avoided when you refinance a mortgage. This can be achieved by including them in the refinancing loan amount. It is known as a no-closing-cost refinance.
However, it will result in a higher interest rate for the same loan. No-closing-cost refinancing is attractive to borrowers who lack the cash to make payments for fees
upfront. Excluding the closing costs could be the practical solution for borrowers who want to refinance a mortgage.
If you won’t stay in your house for over five years, a no-closing-cost refinancing is also sensible. It usually takes over five years to recover the closing costs. The marginally higher interest rate for a no-closing-cost mortgage is very likely. Paying a marginally higher interest rate for the closing costs to be waived could also be sensible for someone that needs cash for renovations in his/her home.
On the other hand, if you will stay in your house for over five years, a no-closing-cost refinancing loan will likely cost you more than when you pay for the closing costs associated with the refinancing loan in the long run.
You will typically break even on the closing costs within a few years. Obtaining a no closing cost loan burdens you with the responsibility of paying a higher interest rate over the duration of the mortgage loan. That could result in costing you much more than paying the upfront fees if you want to stay in the house over a long period.
For example, if you have two options for a $150,000 mortgage refinancing loan. One has an interest rate of 3.75% with associated closing costs of $3,500 while the other has an interest rate of 4.25% without closing costs.
The option with the higher interest rate without closing costs will incur an extra $43.24 in monthly payments. This will amount to an additional $15,567 in 30 years. It will take less than seven years to break even and recover the closing costs with the option of a lower interest rate.
Refinance a Mortgage: Conclusion
It is sensible to refinance your home if you will stay in it long after you break even. Because it is the point at which you actually start saving money when you refinance a mortgage after offsetting the total closing costs of the new mortgage loan.
