To save money, you must stay in your house longer than the "break-even period"
– the period over which the interest savings just cover the refinance costs. The
larger the spread between the new interest rate and the rate on your existing
loan, the shorter the break-even period. The more it costs to obtain the new loan,
the longer the break-even period.
But beware! The break-even period is not the cost of the new loan divided
by the reduction in the monthly mortgage payment. This widely used rule
of thumb is a misapplication of the principle that when explaining something
to the consumer one should "keep it simple." Simple is good, except
when it’s wrong!
The rule of thumb does not allow for the difference in how rapidly you pay
off the new loan as opposed to the old one. Lets say that in 1992 you took out
an 11% 30-year fixed rate loan, which now has a $100,000 balance and 21 years
to run. You refinance into a 7% 15-year loan at a cost of $3,750.
Monthly payment on the old loan = $1019
Monthly payment on the new loan = $899
Reduction in monthly payment = $120
$3750 divided by $120 = 31 months
The rule of thumb says that you break-even in 31 months. However, because of
the shorter term and lower rate on the new loan, in 31 months you would owe
$7,041 less than you would have owed on the old loan. So, the rule of thumb
in this case seriously overstates the break-even period. Taking account of differences
in the loan balance, you would actually be ahead of the game in 12 months, as
shown below:
Savings in monthly payment: $120 for 12 months = $1440
Plus lower loan balance in month 12: $2620
Equals total saving from refinance: $4060
Less refinance cost: $3750
Equals net gain: $310
Next consider the case where an 11% loan taken out in 1992 was for 15 years,
and now has only 6 years to run, while you plan to refinance into a 30-year
loan. With the remaining term shorter on the old loan and longer on the new
one, the difference in monthly payment rises to $1238. Using the rule of thumb
the $3750 cost would be recovered in only 3 months. But this fails to consider
the slower loan repayment on the new loan. Taking account of the slower repayment,
you don’t actually come out ahead until 14 months out.
The rule of thumb (dividing the upfront cost by the reduction in mortgage payment)
approximates the true break-even period only if the term on your new loan is
close to the unexpired term on your old loan. In other circumstances it can
lead you seriously astray.
The rule of thumb also ignores the fact that if you had not refinanced you
could have earned interest on the money you pay upfront to refinance; and if
you do refinance and the payment is reduced, you can now earn interest on the
savings.
My calculator 3a allows you to take account of all the factors that affect
the profitability of refinancing a mortgage. These include the time value of
money, taxes, and differences in the cost of mortgage insurance between the
old and new mortgage. This calculator assumes that you have only one mortgage
and you don't take any cash out of the transaction. Other refinance calculators
are available for borrowers who have a second mortgage or want cash from the
transaction.
January 23, 2001
