Last week, mortgage rates once again flirted with all-time lows, as 30-year fixed rates dropped to…
Refinancing and Breaking Even: When Do I Start Saving?
Refinancing your mortgage loan can help lower your monthly bill. After all, that’s the whole point of refinancing!
As a homeowner, it is important for you to understand how and when you will start realizing these savings.
Once you learn how the new closing costs, loan terms, and interest rates influence your break-even point, you can make an informed decision that maximizes your savings and gets you a step closer to reaching your financial goals.
Defining your mortgage refinance break-even point
In short, you will break even when your overall savings are equal to your total refinancing costs. As a current homeowner, you probably hit a previous break-even point, particularly if you moved from a rental property to a house. After all, many consumers who purchase a home will save money because monthly mortgage payments tend to be lower than the rent on an apartment or a house. However, they will only start to realize their savings (i.e. break even) after recouping all of their initial expenses.
To illustrate, here is an example: A family lives in an apartment and they pay $2,000 per month in rent. The same household purchased a home with a monthly mortgage of $1,000. Their closing costs and downpayment were $10,000. In turn, here is the new homeowners’ break-even timeline:
- Nine months after moving: The total expenses are $19,000 (the closing costs and downpayment plus nine months’ worth of mortgage installments). If they stayed in the apartment, they would’ve paid a lesser amount in rent ($12,000) for that duration. Therefore, the family is yet to break even.
- Ten months: At this point, the household’s mortgage and downpayment will add up to $20,000, which is equal to their total rental expenses (at $2,000 per month) for the same amount of time. In other words, the family will break even ten months after moving into their new house.
- Eleven months: The new homeowners finally start to realize their savings. To clarify, their closing and mortgage expenses would be $21,000. In comparison, staying in a rental apartment would have cost them $22,000 by the eleventh month.
Although the process of refinancing a mortgage is different than the initial purchase, the same break-even calculation applies.
Factors that impact your mortgage refinance break-even point
Homeowners refinance their loans to save money. However, some factors that influence your refinancing break-even timeline are entirely different than the ones that impact the original home acquisition.
One of the most common reasons for refinancing a mortgage is to lock in a more favorable interest rate. More specifically, there are a couple of ways to do so:
- Lower rate: When the current interest rates are lower than what you’re already paying, refinancing your loan will save you money. This is particularly the case if you secure a cheaper interest payment.
- Fixed interest: Some homeowners have an adjustable rate, which fluctuates based on the prevalent market conditions. Attaining a fixed and relatively lower interest can reduce your monthly payment, especially when the overall market rates are expected to start trending upwards in the distant future.
Simply put, the difference between your original and refinanced interest payments will determine how much you save.
Nonetheless, to accurately identify your mortgage refinance break-even timeline, other loan features are equally as important as the new interest rate.
The loan term
The length of your loan defines both your long and short-term savings. Homeowners typically follow one of two strategies:
- Shorter term and higher payments: Under this approach, you could pay down your mortgage sooner by reducing its term to ten or fifteen years. In turn, you would pay less in interest over the lifetime of the loan, but your monthly payments will likely increase with a shorter mortgage.
- Longer term and lower payments: A 15 or 20-year loan term, on the other hand, would reduce your monthly costs. However, you should keep in mind that your total interest will be higher over the lifetime of the mortgage.
Borrowers who lock in lower refinance rates can save money with both of these approaches. A shorter term allows you to break even relatively quicker, but the higher payments may not be suitable for everyone. A 15 or 20-year mortgage, on the other hand, benefits homeowners who want to reduce their monthly housing bill, even if that means waiting longer to break even.
Lastly, but certainly not least, your mortgage refinance break-even point largely depends on your related closing costs. Just as with your original loan, you may have to pay certain up front expenses when refinancing your home:
- Application and loan fees: When you initially apply to remortgage your property, lenders will ask you to pay these fees in order to process the application and issue the new loan.
- Appraisal and inspection expenses: Before refinancing your home, you may have to work with an inspector to verify that your house is still inn good shape and did not incur significant damages. Similarly, you might need to hire an inspector to ensure that there aren’t any problems related to the structure, water pipes, or bug infestations.
- Insurance: If you paid down less than 20% of your mortgage balance, you will need to retain your title insurance policy. Add that to your break-even calculation.
- Early payment penalties: Check your original loan papers and find out if your lender will charge you for paying down the mortgage early (which applies to refinancing). At times, you may break even sooner if you wait until the early payment period ends, especially if the penalty is relatively expensive.
Calculating your mortgage refinance break-even point
After taking the updated interest rate, new loan term, and closing costs into account, you can start determining your mortgage refinance break-even level.
To do so, follow these steps:
1. Compare the old and new payments
How much are you paying per month before and after refinancing? First and foremost, find the different between the two bills based on the loan amount, the interest rate, and term.
To clarify, here is an example that you can follow while calculating your mortgage refinance break-even point:
A homeowner has a mortgage balance of $300,000. Under a 20-year term and a 3% annual interest rate, their payments are as follows:
- Per year: $15,450 ($15,000 in principal and $450 in interest)
- Per month: $1,290 ($1,250 in principal and $40 in interest)
The homeowner decided to refinance. They locked in a lower interest rate of 2% and increased their term to 30 years on the same $300,000 loan amount. Therefore, their new mortgage bill is as follows:
- Per year: $10,200 ($10,000 in principal and $200 in interest)
- Per month: $850 ($833 in principal and $17 in interest)
In turn, the homeowner would save over $5,000 annually and more than $400 monthly. However, the closing costs should also be added to the equation.
2. Add the fees, appraisal/inspection expenses, and other costs
Let’s assume that the homeowner in our above example incurred $10,000 in closing costs and decided to pay them up front. There are two ways for them to come up with the new mortgage refinance break-even timeline:
- Through dividing the closing costs by the yearly or monthly payment. For instance, if they divide the $10,000 in expenses over the $5,000 in annual savings, it would take the homeowner about two years to break even. Similarly, dividing the closing costs by the monthly savings gives us the number of months it takes for the homeowner to break even after they refinance.
- Another way to identify your break-even timeline is through the same calculation we used in the example of the family that moved from an apartment into a home. In short, add the closing costs to your new monthly mortgage bill and compare your total savings (in relation to the previous payment) on a month-by-month basis. Once the refinanced mortgage’s costs surpass the overall monthly payments on the older loan, you will break even.
Special situations and your mortgage refinance break-even point
There are several certain circumstances that may alter your break-even calculation.
The following are the most common ones:
Adding the closing costs to the mortgage amount
Instead of paying the closing costs up front, some homeowners prefer to add them to the loan amount. This is particularly the case when a borrower cannot afford to cover the closing expenses in one large payment.
If you decide to add these costs to your loan, compare the total principle and interest payments to those on your original mortgage. Since the closing expenses incur interest when you don’t take care of them up front, you could end up paying more in the long-term after refinancing.
When your refinanced monthly payments are lower than the previous ones, and you choose to keep the same loan length, you will break even and start saving money immediately. This is because your new bill is lower, and there aren’t any other up front expenses that influence it.
If you shorten or lengthen your refinanced mortgage term, simply add up the old and new payments on a month-by-month basis. Once the accumulated amount on the refinanced loan is lower than that on the original mortgage, you break even. This is nearly identical to the calculation we used in the example of the family that moved from an apartment to a home, but without adding a downpayment or any up front closing costs.
Some homeowners take out a larger loan than their mortgage balance, especially when their house’s value goes up.
One of the most common reasons for cash-out refinancing is to use the money for renovations and home improvement. This could make your long-term expenses larger than what they were with the original mortgage. However, improving your house can boost its price and save you money if you refinance again in the future.
Click here for our guide on how to increase your home’s value.
Another reason for cash-out refinancing is debt consolidation. More specifically, borrowers may combine other high-interest debt (such as credit cards and auto loans) with their mortgage in order to attain an overall lower rate.
If you cash out and consolidate other debts, here is how you can calculate your new mortgage refinance break-even point:
- Add up the monthly or annual payments on the original mortgage loan and the consolidated debt.
- Compare your new bill, which has a lower interest rate, to your old mortgage and debt payments. The difference between them is how much you save.
Lastly, but certainly not least, don’t forget to account for closing costs. If you pay for these expenses up front (instead of adding them to your consolidated loan), just follow our examples above to determine your mortgage refinance break-even point.
As this article shows, refinancing your mortgage can be a great way to save money, reduce your monthly expenses, and even obtain extra cash.
If you are thinking about refinancing, check out Refily’s lender matching tool to learn more about your home refinance options.
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