Mortgage Loan Refinance Breakeven Points

Sometimes saving money just involves being lucky. I don’t really keep up with mortgage rates anymore, but last week an e-mail subject line just happened to catch my eye that mortgage rates are at “record lows”. I always figured that my 5.125% rate was so low that another refinance or loan modification probably would never be worth it, but it turns out that rates are so low they just might. Here’s a quick snapshot of rates from a Wall Street Journal article on 7/16/10:

The 30-year fixed-rate mortgage averaged 4.57% in the week ended Thursday, unchanged from a week earlier and down from 5.14% a year earlier. Rates on 15-year fixed-rate mortgages were 4.06%, extending the lowest point since Freddie started tracking it in 1991, and down from 4.07% last week and 4.63% a year earlier. [...] To obtain the rates, the mortgages required payment of an average 0.7 point. A point is 1% of the mortgage amount, charged as prepaid interest.

has ads now for 4.25% fixed for 30 years and 3.75% for 15 years. As for me, I might be able to get my interest rate below 4.75% and have a “breakeven” period of less than 3 years. I’m awaiting official paperwork. Ask your loan servicer and/or mortgage broker what they can do for you. Can’t hurt to ask!

Meanwhile, I was playing with the Refinance Breakeven calculator over at DinkyTown and found out that there are multiple definitions of “breakeven period”. Before, I simply figured that a refinance would cost X dollars upfront in fees and closing costs, but would save me Y dollars per month. Divide X by Y, and you’d have a breakeven point. For example, if it cost you $2,400 in fees but saved you $100 per month, you’d break even in 24 months. Past that, you’re saving $100 every month. In this case, if you plan to keep your mortgage for longer than 24 months, then refinancing makes sense.

However, there are actually four possible breakeven methods presented:

  1. Monthly payment savings. The simple formula described above. The number of months it will take for your monthly payment reduction to be greater then your closing costs. Doesn’t take into account that you may be making more monthly payments.
  2. Interest savings (plus PMI if applicable). The number of months it will take for your interest and PMI savings to exceed your closing costs.
  3. After-tax interest savings (plus PMI if applicable). The number of months it will take for the after-tax interest and PMI savings to exceed your closing costs. This takes into account that the interest and PMI being paid may be tax-deductible, while the closing costs are paid with after-tax money only. Depends on your income tax rate.
  4. Total after-tax interest savings vs. prepayment. This is the most conservative breakeven measure, and will result in the longest breakeven time period. This method considers that you could take the amount spent on refi closing costs and instead make a large prepayment on your existing mortgage. Then, it calculates the number of months it will take for the after-tax interest and PMI savings to exceed both the closing costs and any interest savings from prepaying your mortgage.

Which method is best?

First, I should add that you could complicate things even further by assuming any money not paid out immediately could earn a rate of return (savings accounts, CD, etc.) But that would make my head explode, so I won’t. The calculator suggests that methods #2 and #3 are most commonly accepted, and I would tend to agree. If you are sure that your interest is 100% tax-deductible (you exceed the standard deduction provided by the IRS without it), then you should use the value from #3. Otherwise, something in between #2 and #3 is probably the most accurate.

Method #4 compares with another theoretical situation that only applies if you really want to make a lump-sum prepayment and keep the higher monthly mortgage payment over a shorter mortgage term. For many people, the goal is to lower the monthly outlay and improve cashflow as well as save money on interest.

Comments

  1. Another consideration is to find a good mortgage broker that will find a lender to do a no-points no-closing cost refinance. Recently I refinanced at 4 5/8% on a 30 yr. fixed rate mortgage. This way from day 1 your ahead of the game and if rates do drop further, you refinance again at the lower rate.

  2. ChrisMR says:

    When we refinanced I had the following goals:
    (1) keep monthly payments close to what they had been (~$150/mo window)
    (2) cut length of mortgage (went from 25 left on 30yr to a 20yr)
    (3) have a break-even point within 2 years – for me that meant interest not paid to the bank vs refinancing costs.

    I accomplished all 3, so it was a no brainer. I think looking at knocking a couple of years off the length of the mortgage is a good way to go, it helps you save a lot of interest paid very quickly.

  3. Steve N. says:

    Have you considered refinancing into a 15 year mortgage? In the past, you have talked about paying extra principal on your mortgage anyway. It would be interesting to see how much more your payment would increase on a 15 year vs. a 30 year mortgage. Given the 15 year mortgage has a much lower interest rate and you have already paid a bunch of the principal off, my guess is your payment would not increase that much.

  4. enonymous says:

    Why not just obtain a quote for a true no-cost refi rate?

    This essentially amounts to negative points, as this is how the borker/lender’s closing costs for title etc are paid to te lender/broker.

    WIth a true no cost quote, there is no break even period – if the rate is lower than your current rate, you save money. Period.

    I’ve always done no cost refi’s since I prefer to keep the put optionality of a mortgage intact immediately, especially given that I always choose a 30 yr fixed, have lowered the loan amount with each refi, and have been consistent in my belief that rates are stgnant and or will continue to fall. Could get a better rate by paying points? Sure. BUt then I would NEED to know how long I am keeping the home and/or need to know what rates will do in the future.

    The other benefit of a true no cost refi is that you never feel like you can get cheated or bait/switched on closing costs (inflated title insurance or lender fees etc).

  5. I refinanced from 30 years to 20 this past December at 4.5% and will do it again now to 15 and pay points which I have never done before. I am now getting 3.625% with 1 pt and 2,500 in closing costs. I calculate breakeven at 2.5 years. This is an amazing opportunity to lock in an incredible rate. Of course I could be wrong again and rates continue to decline but that seems extremely far fetched.

    If you will be staying in your home more than 3 years points may be worth considering to buy the rate down to extremely low levels. Finally you do need a pretty high FICO to get this kind of deal. Mine is usually in the 770-780 range.

  6. How would you calculate your breakeven point going from a 30 year 6.5% mortgage to a 15 year 4.25% mortgage? You’re going to end up paying more a month because of the shorter term but the principle will be paid faster too. My wife thinks we are wasting money to refinance and I’m trying to prove her wrong. Any help is appreciated. :)

    Also, what exactly would you put for “other closing costs”?

  7. acoward says:

    Don’t forget inflation… Money upfront today is more valuable than money 10 years from now.

  8. We are at the end of a 7 year ARM in Sept which we rode out because the rate was so low at 4.25%. Now we are refinancing into a 30 year at 4.75% (we are in IL) and there is no cost to us – I guess they roll the costs into the new principal? Not sure, I need to look at the paperwork when we get it. I think we are getting a good rate.

    I pushed for a 15 year, since this mortgage is totally affordable to us (equal to 1.5 year of our income)- but my husband (and the broker) were wary because of the economy, unforseen expenses with kids, etc. Paying down principal early will be our plan going forward.

    Thanks for the post and interesting comments.

  9. Man… I locked in a rate and bought a house back in December at 4.75% with no points. I thought I had bottom ticked a 40 year period.

    For those who are thinking about buying gold as an inflation hedge, probably better to refi your house and have a big fat loan out at 4.35% or so.

    No better inflation hedge than owing a lot of money you can repay in cheap dollars…

  10. @ Maury: What good is taking out a huge loan to hedge inflation? If you are just going to put that money in the bank, that money will become cheap dollars, and there’s no ultimate benefit. Unless you are suggesting taking that money and going on a spending spree, I don’t see the point.

  11. when I first looked into buying a house in 2004 everyone said “these are the lowest rates ever, definitely buy now because they will go up soon.”

    When I looked again in 2006 I heard “these are the lowest rates ever, definitely buy now because they will go up soon.”

    When I actually bought in 2007 I heard “these are the lowest rates ever, definitely buy now because they will go up soon.”

    When I refinanced in 2009 I heard “these are the lowest rates ever, definitely refinance now because they will go up soon.”

    Now today I am hearing “these are the lowest rates ever, definitely refinance now because they will go up soon.”

    I agree with the poster above who suggested only refinancing if you can do a true no cost refi and get a better rate. Otherwise you end up paying points and locking yourself in for a period of time to “break even”

  12. Very good post. Essentially, you want to divide the cost by the INTEREST savings cost, not the total cash flow since some of it goes to principle.

  13. I would say these are the lowest mortgage rates you will see in a long time. You are right in saying that you should only refinance if you can truly get a better rate out of it, and the downfall of making the wrong decision is that you are locked in until you break even.

  14. Anyone recommend a good lender that have good rate that does no closing cost loan? Thanks

  15. How about when all the costs are rolled into the new loan. For example, your current loan principle balance is $250,000. When the new loan is closed, the $5000 in cost/pre-paid/etc was simply rolled into the new loan giving you a new loan amount amount of $255,000.

    If you compare amortization the original loan with the amortization of the new loan, you should see pretty easy when you “break-even”, with the following condition that the new loan amortization is amortized as follows:

    1) You continue to pay the new loan at the same P&I as the original loan. The new loan will be a lower P&I, so you essentially be adding monthly payments.
    2) Typically, you end up skipping a month of mortgage payment. So in the amortization, you need to factor in a one time pre-payment to the new loan equal to the monthly payment you would have paid had you stuck with the original loan.
    3) Pre-paids (taxes, ins, etc) was added to the new loan amount, but you also typically get a refund from the old escrow account. So that factor that refund into the amortization of the new loan as another one time pre-payment.

    Now when you compare the original loans amortization with the new loan’s amortization schedule, you should see in the amortization schedule when the new loan catches up with the original loan. At the month and year would be the break-even point.

    I’ve seen the 4 methods above before, but nothing that describe what I just did above. Is there a major flaw in my method?

    Perhaps my method was only applicable to my specific situation. If so, I’ve offered the actual numbers I was dealing with below. Would appreciate any feedbacks from your side.

    Original Loan: 274500
    Int rate: 5.25
    Loan Start Date: 4/1/2011 (first payment on 5/1/2011)
    No PMI: PMI was pre-paid

    New Loan: 278500 (all costs included – closing, pre-paids, pre-paid PMI)
    Int Rate: 3.99
    Loan Start Date: 5/1/2012 (first payment on 6/1/2012)
    No PMI: PMI is to be pre-paid (included in closing costs)

    With the refi, I would be skipping 5/1/2012 mortgage payment (a payment I would have made if I stuck with the original loan). That payment is $1791 (P&I + ins + tax). So I factor that into the amortization as a one-time pre-payment to the new loan.

    I would also get a refund from the previous escrow of about $1250. So I factor that into the amortization as a one-time pre-payment to the new loan.

    When I plug these numbers in and compare the two amortization schedules, I see the new loan catches up with the original loan on Dec 2013.

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