When does refinancing actually pay for itself?

Refinancing is the one mortgage decision with a clean arithmetic test, which is probably why so many people stop at the test and skip everything around it. The test is worth doing. It just answers a narrower question than most borrowers think.

The break-even calculation

Take what the refinance costs you at closing. Divide it by the amount your monthly payment goes down. The answer is how many months you have to stay in the loan before the refinance has paid for itself.

If it costs $5,000 and saves $180 a month, that is 28 months. Stay past month 28 and you are ahead. Sell or refinance again before then and you paid $5,000 for nothing.

Rolling the costs into the balance does not change this. The money still gets paid — it just comes out of your equity instead of your bank account, and then you pay interest on it for the rest of the term.

What break-even does not tell you

Here is the part the monthly-payment comparison hides. A payment can go down because the rate went down, or because the term got longer, and those are not the same event.

Every refinance restarts the amortization schedule. That matters more than it sounds, because a mortgage is front-loaded with interest. On a $300,000 balance at 7% over 30 years, the payment is about $1,996. In the first twelve months of that loan, roughly $20,903 goes to interest and only $3,047 goes to principal — 87% of what you pay in year one buys you nothing but time.

If you are eleven years into a 30-year loan, you have worked your way partly out of that. Refinancing into a fresh 30-year term puts you back at the start of it. Your payment falls, your interest cost over the life of the loan can easily rise, and break-even — which only looks at monthly cash flow — will tell you the deal is fine.

The fix is not complicated: compare against a shorter term too. Refinancing a 19-year remaining balance into a 20-year loan rather than a 30 keeps most of the progress you already made. The payment relief is smaller. The total cost is usually much better.

You can run both the payment saving and the total-interest comparison on the refinance calculator, which is the pair of numbers worth seeing together.

"No-cost" refinances

There is no such thing as a refinance with no costs. There are refinances where the costs are paid by the lender in exchange for a higher rate, which is a real option and sometimes the right one.

The way to tell what you are being offered: a genuine no-cost refinance has a rate visibly above the market rate that day. If a lender offers you the market rate and no costs, the costs are in the loan amount. Ask what the balance will be on day one and compare it with your balance today.

The break-even on a no-cost refinance is immediate, because nothing was spent. The trade is that you carry the higher rate for as long as you keep the loan, so it works well when you expect to move or refinance again soon, and poorly when you expect to stay.

The disclosure that makes comparison possible

You do not have to take anyone's word for the costs. Once you give a lender six specific pieces of information — your name, your income, your Social Security number, the property address, an estimate of the property's value, and the loan amount you want — that counts as an application, and the lender must deliver a Loan Estimate within three business days.

A lender cannot require anything beyond those six items before issuing one. If you are being told you need to supply more paperwork, or pay something, before you can see written numbers, that is not a rule — that is a sales step.

Collect Loan Estimates from more than one lender on the same day, since pricing moves daily, and compare page 2 line by line.

What to ask

• How long do you expect to keep this loan? If the honest answer is under the break-even period, the rest of the comparison does not matter.
• What term am I being quoted, and what term do I have left? A lower payment over a longer schedule is a cash-flow decision, not a savings one.
• What is the total of the closing costs, and are any of them being rolled in?
• What would the rate be with no lender credit, and with the largest credit you offer? Those two quotes bracket the deal.

Break-even is the floor. The question underneath it is whether you are buying a lower rate or just a longer schedule — and that one the payment alone will never answer.

Sources: CFPB TILA-RESPA Integrated Disclosure FAQs on the three-business-day Loan Estimate requirement and the six items that constitute an application. Payment and interest figures computed with this site's own amortization.