Refinance break-even: the true-cost method

The usual formula

Many guides give a simple rule for refinancing. Divide your closing costs by your monthly savings. The answer is your break-even month. This is the month when your monthly savings add up to the cost of the refinance.

The rule is easy to use. It needs only two numbers. In our example, the upfront cost is $5,000. The new loan saves $424 each month. With the usual formula, the simple break-even is month 12.

On paper, this looks like a clear answer. If you plan to stay in the home past month 12, the refinance seems to pay off. The rule is fast, but it is incomplete. It leaves out parts of the real cost.

Why the usual formula misleads

The usual formula hides three things.

First, a new 30-year term lowers your payment partly because it pays the principal back more slowly. Principal is the part of each payment that reduces what you owe. A longer term gives you a smaller payment, but you repay the balance over more years. The formula counts the lower payment as a full gain. It does not show the cost of the longer term.

Second, fees added to the loan seem to cost nothing at closing. Some lenders let you roll closing costs into the loan. You do not pay them in cash on the day you sign. The formula ignores them. The fees still raise your balance, and you pay interest on them for the life of the loan.

Third, the formula treats principal as a cost. Principal is not money you lose. Each payment that reduces principal raises your equity. Equity is the part of the home that you own. When the formula counts principal as a cost, a new loan that pays down less principal each month looks cheaper than it is.

The true cost

Use a better method to find your break-even. Count three things: interest, fees, and PMI. PMI, or private mortgage insurance, protects the lender. On a conventional loan, the lender usually requires PMI when the loan is more than 80% of your home’s value. Do not count principal, because you keep it as equity.

Use the same example. The true break-even is month 23. The simple break-even was month 12. The true method gives a later month because it counts only interest, fees, and PMI. It does not count the slower payoff of principal as a saving, so the real saving each month is smaller than the drop in your payment.

Here is how the true method works. For your current loan, add up the interest and PMI you pay each month. For the new loan, start with the fees at month 0, then add the interest and PMI you pay each month. The true break-even is the first month when the new loan’s total is no higher than the current loan’s total.

This is the method the RefiROI calculator uses. It shows both totals on one graph, so you can see where the lines cross. The point where the new loan’s line drops below the current loan’s line is your true break-even.

The true-cost method works for any refinance. Replace the example figures with your own.

The later crossing

A longer term can change the result over time. The new loan may cost less each month. Yet it can cost more in total. This happens when the longer term adds years of interest.

In the example, the lines cross twice. Before month 23, the new loan costs more in total. Between month 23 and month 188, it costs less. After month 188, it costs more again. That is after year 15.

Compare the two dates. Ask how long you expect to keep the home. If you plan to move after month 23 but before month 188, the new loan costs you less. If you plan to stay longer, check the later crossing before you decide.

Want to see your own numbers? Open the calculator. Your numbers stay in your browser.