MoneyLifeCalcA lower mortgage rate sounds like free money, but refinancing has a price. You are taking out a new loan, with new closing costs, to pay off the old one. Whether it is worth doing comes down to one question: will you keep the new loan long enough for the savings to cover the cost?
What refinancing costs
Closing costs on a refinance often run 2% to 5% of the loan amount. They typically include a lender origination fee, an appraisal, a title search and title insurance, recording fees, and prepaid interest, property tax, and insurance. On a $300,000 loan that is roughly $6,000 to $15,000. Within a few days of applying, each lender must give you a Loan Estimate that lists these costs in a standard format, which makes offers easy to compare.
The break-even calculation
The basic math is one division: closing costs divided by the monthly savings gives the number of months to break even.
Here is the example from our Refinance break-even calculator. You owe $300,000 at 7.25% with 27 years left, and your payment of principal and interest is $2,112.58. A new 30-year loan at 6.25% has a payment of $1,847.15, saving $265.43 a month. Closing costs are $6,000. Dividing $6,000 by $265.43 gives about 23 months, so you break even in just under two years.
How long will you stay?
Break-even only matters in comparison with your plans. In the example, staying 7 years produces a net saving of about $13,484, after counting the closing costs and the balance still owed on each loan. Selling at 2 years leaves you about even. Selling at 1 year leaves you about $3,000 behind.
Be honest about this. A job change, a growing family, or a plan to downsize can all end a mortgage earlier than expected.
The trap of restarting the clock
In the example, the old loan had 27 years left and the new one runs 30. Part of the lower payment comes from the lower rate, and part comes from simply stretching the debt over three more years. That is why the calculator shows two interest figures: about $384,477 of interest remaining on the old loan and about $364,975 on the new one. The saving in total interest is much smaller than the monthly saving suggests.
There are two ways to avoid this. You can choose a shorter new term. A 20-year loan at the same 6.25% raises the payment to $2,192.78, about $80 more than you pay now, but total interest drops to about $226,268. The calculator will report no monthly savings in that case, because the benefit is arriving as a faster payoff. Or you can take the 30-year loan and keep paying your old, higher amount, sending the difference to principal. That gives you the lower rate, a faster payoff, and the freedom to fall back to the smaller payment in a hard month.
Cash or rolled into the loan?
You can pay closing costs at the table or add them to the new balance. In the example, rolling in the $6,000 raises the payment to $1,884.09, stretches break-even to 2 years and 2 months, and lowers the 7-year saving to about $10,978. Rolling costs in keeps your savings intact today, and you pay interest on those costs for as long as you keep the loan.
Some lenders advertise a refinance with no closing costs. The costs still exist. They are covered by a higher interest rate. That can be a reasonable trade if you expect to move or refinance again within a few years, and a poor one if you stay.
Points
Discount points are fees paid up front in exchange for a lower rate. One point costs 1% of the loan. Points are the same break-even question in miniature: divide the cost of the points by the monthly saving they buy, and compare that with how long you will keep the loan.
When refinancing usually makes sense
- You will stay in the home well past the break-even point.
- The new rate is meaningfully lower, and your credit and home equity qualify you for it.
- You want to move from an adjustable rate to a fixed rate for stability.
- You want to shorten the term and can afford the payment.
When it usually does not
- You expect to move before breaking even.
- You are many years into the current loan and the new one would restart a long term.
- The rate difference is small compared with the costs.
Steps before you apply
- Check your current balance, rate, and years remaining on a recent statement.
- Ask at least three lenders for a Loan Estimate on the same day, since rates change daily.
- Compare the rate, the points, and the total closing costs on each.
- Run each offer through the calculator with the number of years you realistically expect to stay.
To see how the new loan would look in full, including taxes and insurance, use the Mortgage payment calculator.