When does it pay to refinance a mortgage?

Refinancing your mortgage can be an excellent opportunity to save money and get better terms on your home loan. But while refinancing can mean big savings in the medium to long term, it does carry a number of upfront costs.

To help you decide on the right time to refinance, you need to determine your break-even point. In other words, you need to know how long it will take for the money you save with your new mortgage to exceed the costs of acquiring it.

Simple formula for calculating your break-even point:

Step 1: Subtract your new monthly payment from your old monthly payment to calculate the savings each month.

For example:
Say you have $170,000 of principal remaining on a 30-year fixed-rate mortgage you took out 5 years ago at 8 percent:
Your current monthly payment is $1,312.

If you refinanced to a new 30-year mortgage at 6.5 percent:

Your new monthly payment would be $1,075.
$1,312 (Old monthly payment)
- $1,075 (New monthly payment)
= $237 (Savings per month)

Step 2: Divide the closing costs of your new loan by the monthly savings to calculate your break-even point.

For example:
If the closing costs are $4,800:
$4,800 ÷ $237 = 20.25 months

So, according to this formula, you start to save on your mortgage refinancing in less than 21 months.

Other factors to consider:

1. The effect of extending your term
The problem with the above calculation is that it ignores an important factor. Your new monthly payment isn’t just reduced because of a lower interest rate; it’s also lower because you’ve effectively extended the term of your loan. If you’ve had a 30-year mortgage for five years, then you have 25 years left to pay it off completely. But if you refinance to a new 30-year loan, you’ll face five extra years of monthly payments, which the formula ignores.

If your new mortgage had a term of 25 years instead of 30, allowing you to pay down that $170,000 in the same amount of time, your monthly payment at 6.5 percent would be $1,148, making your break-even point more than 29 months. Refinancing still makes sense if you plan to stay in your home for several years -- over the life of the loan, you would still pay less interest with the new mortgage -- but the savings would take longer to realize than the simplified formula suggests.

2. If you choose a shorter-term loan
Now imagine you’re in the same situation as above, but this time after five years you decide to refinance to a 15-year mortgage in order to pay off your home more quickly. The new monthly payment at 6.5 percent would be $169 higher, so the old break-even formula doesn’t apply. Over the life of the loan, however, the new loan will save you a whopping $127,000 in interest, since more of your money is going to pay down the principal, and you will own your home 10 years sooner!

In short, the rule of thumb for calculating your break-even point is only accurate when the term of your new loan is very close to the term remaining on your old one -- and that’s often not the case.

There are other things to consider when you refinance, too, including taxes and private mortgage insurance. For a break-even estimate that takes many of these factors into account, use the LendingTree refinancing calculator.