Should You Refinance? A Break-Even Checklist

A lower rate is tempting, but refinancing is a purchase: you pay closing costs now to save on payments later. Whether it is worth it depends on how long you will keep the loan and how the new term compares with the time you have left.

The break-even test

The simplest test is the break-even point:

Break-even months = closing costs ÷ monthly savings

If you will keep the loan longer than that, the refinance pays off on a payment basis.

A worked example

Say you owe $300,000 at 7.0% with 28 years left. You are offered a new 30-year loan at 6.0% with $6,000 in closing costs.

	Current loan	New loan
Rate	7.0%	6.0%
Term	28 years left	30 years
Monthly principal and interest	$2,038.83	$1,798.65

The payment drops by $240.18 a month. The break-even is $6,000 ÷ $240.18, about 25 months.

That looks attractive, but notice that part of the savings comes from stretching the term by two years. A fairer comparison keeps the term the same. A new loan at 6.0% over 28 years would have a $1,845.37 payment, saving $193.46 a month, and the break-even would be about 32 months. The refinance is still worthwhile, but the savings are smaller than they first appeared.

The term-reset trap

Taking a new 30-year loan restarts the clock. A lower payment can come with more total interest over the life of the loan if you keep it to the end. You have two ways around this: choose a term close to what you have left, or keep paying the old payment amount so the extra goes to principal. The refinance calculator compares interest over your expected stay and over the whole life of both loans.

When refinancing usually makes sense

• The rate is meaningfully lower, and the break-even is shorter than the time you expect to stay.
• You can pay the closing costs in cash without draining your emergency fund.
• The new term is similar to what remains on your current loan, or you will keep paying the higher amount.
• You want to remove mortgage insurance or switch from an adjustable rate to a fixed rate.

When to think twice

• You may move in a few years, before the break-even date.
• You would extend the term a long way and mainly lower the payment.
• You plan to roll closing costs into the loan, which raises the balance and the interest.
• You have little equity, which can mean higher costs or a harder approval.

Checklist

1. Get written Loan Estimates from at least three lenders.
2. Calculate the break-even for each, using total closing costs.
3. Compare lifetime interest, not only the monthly payment.
4. Check for a prepayment penalty on your current loan.
5. Compare the APR for loans with different points and fees, using the APR calculator.
6. Make sure you will keep the home past the break-even date.

Common questions

How low does the rate need to be to refinance?

There is no universal number. Some people use a drop of about three-quarters to one percentage point as a rule of thumb, but the break-even point is a better guide: if you will keep the loan well past the months it takes to recover the closing costs, a smaller drop can still pay off.

Can I refinance if I owe more than the home is worth?

It is difficult with a conventional loan, and you would generally need to bring cash to closing. Some government-backed loans have streamlined options that do not require a new appraisal, so ask your lender about the choices for your loan type.

Should I do a cash-out refinance?

A cash-out refinance replaces your loan with a larger one and pays you the difference, which converts home equity into cash but increases your balance and may raise your rate. It can make sense for a worthwhile purpose such as a major repair, but it puts your home at risk if you cannot afford the larger loan. Compare it with other ways to borrow.

Key takeaways

• Break-even months = closing costs divided by monthly savings.
• Compare the new loan with the same remaining term, not just the new payment.
• Do not refinance if you may move before the break-even date.