Is Refinancing Worth It? Closing Costs, Break-Even and Traps

The question is refinancing worth it has one honest answer: it depends on three numbers, and the lender’s ad only shows you one of them. The rate is the one in the ad. The other two are the closing costs and how long you will keep the loan. This guide gives you the test, runs it on a $350,000 mortgage at 7.25% with 25 years left, and lists the four situations where a refinance that looks good is a loss. Check your own numbers in the refinance calculator as you read.

The break-even test

Refinancing costs money up front and saves money every month. Divide the one by the other and you get the break-even: the number of months until the saving has paid back the costs. If you will keep the loan longer than that, the refinance is worth it. If you will sell or refinance again sooner, it is not.

On the example loan, refinancing from 7.25% to 6.25% for $9,000 of closing costs lowers the principal-and-interest payment from $2,530 to $2,309, a saving of $221 a month. Break-even is 9,000 ÷ 221 = 41 months. Keep the loan five years and you are $4,260 ahead; keep it the full 25 and you are $57,000 ahead. Sell after two years and you are $3,700 behind.

The old rule of thumb, refinance when rates drop a full point, comes from this table. A quarter-point cut takes 13 years to pay for itself on typical costs; a full point pays back in under four.

Trap 1: the term reset

Most refinances are written as new 30-year loans, and the lender’s quote shows the payment on that basis. On the example, a new 30-year loan at 6.25% has a payment of $2,155, a saving of $375 a month, which makes the break-even look like 24 months. But it adds five years to the loan. Total interest on the new 30-year is $425,804; on a 25-year at the same rate it is $342,653; on the old loan it was $408,947. The “saving” of $375 a month comes with $17,000 more interest than doing nothing.

Always compare on the remaining term. If the lender will not write a 25-year loan, take the 30-year and pay the 25-year payment, which gets you the same result as long as you keep it up. The extra payment calculator shows what the extra amount does.

Trap 2: no-closing-cost refinances

There is no such thing; the costs are paid through a higher rate. On the example, a no-cost loan at 6.625% instead of 6.25% saves $139 a month instead of $221. Over 25 years that is $24,600 less saving, far more than the $9,000 of costs it avoided. The no-cost option makes sense only if you expect to sell or refinance again within about four years, because then you never reach the break-even on the paid-cost loan anyway.

The same logic covers rolling the costs into the loan. You avoid writing a check, but you pay 6.25% interest on $9,000 for 25 years, about $5,000 extra. Pay the costs in cash if you have it.

Trap 3: refinancing late in the loan

The saving comes from the interest ahead of you, and late in a loan there is not much. A $150,000 balance at 7.25% with ten years left, refinanced to 6.25%, saves $77 a month, and $9,000 of costs takes 118 months to recover, nearly the whole term. The amortization schedule shows the interest remaining at any point; if it is under about $50,000, a refinance rarely pays unless the costs are tiny.

Trap 4: the cash-out that is really a consolidation

Rolling credit card balances into a cash-out refinance turns 22% debt into 6.5% debt, which is a real saving. It also turns unsecured debt into a lien on your house, stretches a two-year problem over 30 years, and in our experience often leads to the cards being run up again. If you do it, keep the term short and close the cards you consolidated.

The number the ads leave out: how long you will stay

Everything above depends on holding the loan past the break-even, and most people overestimate how long they will. The median homeowner in the US moves every 12 to 13 years, but that figure is pulled up by people who never move; among buyers under 40, five to seven years is common. Job changes, growing families and divorces do not consult the mortgage. If there is any real chance of moving within four years, treat the break-even as the test it is and be honest about the answer.

A refinance you will keep eight years should also be judged on eight years of saving, not 25. On the example, eight years at $221 a month is $21,200, which after $9,000 of costs is a net $12,200. Worth doing, but a third of what the full-term figure suggests.

A note on cash-out rates

Cash-out refinances price higher than rate-and-term, often by a quarter to half a point, and the higher rate applies to the whole balance. If you need $40,000 of equity and your current rate is good, a home equity loan or line of credit on top of the existing mortgage is usually cheaper than refinancing $350,000 at a worse rate to get $40,000 out. Run both: the cost of the second lien on $40,000 against the extra interest on the whole refinanced balance.

When refinancing is clearly worth it

Your rate is at least three-quarters of a point above current rates and you plan to stay five or more years. You are on an adjustable-rate mortgage approaching its first adjustment and the fully indexed rate is above the fixed rates on offer. You have an FHA loan with permanent mortgage insurance and now have 20% equity, so a conventional refinance drops the insurance as well as the rate. You can move from a 30-year to a 15-year loan at a lower rate without straining the budget, which cuts total interest by more than half.

When to stay put

Your rate is within half a point of current rates. You expect to move within three years. Your credit score has fallen since you got the loan, so the new rate would not be much better. You are within ten years of paying off the loan. Or your current lender will do a rate modification for a flat fee, which a few do for borrowers they want to keep; ask before you apply elsewhere.

Running your own test

Open the refinance calculator with your current balance and rate from the latest statement, the rate on a real loan estimate (not an advertised rate), the months left, and the lender, title, appraisal and recording fees from section A through C of the estimate. The result gives the net saving over the remaining term and the break-even month. If the break-even is inside the time you expect to keep the home by a comfortable margin, go ahead. Then use the loan payment calculator to see the payment on a shorter term and decide whether to take it. Other tools are on the homepage.

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