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To save money, you must live in your house longer than the
"break-even period" - the period over which the interest savings
just cover the refinance expenses. The larger the spread between
the new interest rate and the rate on your existing loan, the
shorter the break-even period. The more it cost to get the new
loan, the longer the break-even period.
But be careful. The break-even period is not the cost of the new
loan divided by the decrease in the monthly mortgage expense.
This broadly used rule of thumb is a misapplication of the
principle that when explaining something to the buyer one should
"keep it simple." Simple is fine, except for when it is wrong.
The rule of thumb does not permit for the difference in how
rapidly you pay off the new loan as opposed to the old one. Let
us say that in 1996 you took out an 11% 30-year fixed rate loan,
which now has a $100,000 balance and 21 years to run. You
refinance into a 7% 15-year loan at a fee of $3,750.
Monthly expense on the old loan = $1019
Monthly expense on the new loan = $899
Reduction in monthly expense = $120
$3750 divided by $120 = 31 months
The rule of thumb say that you break-even in 31 months. But,
because of the shorter term and lower rate on the new loan, in
31 months you would owe $7,041 less than you would have owed on
the old loan. So, the rule of thumb in this case critically
overstate the break-even period. Taking account of difference in
the loan balance, you would actually be in advance of the game
in 12 months, as showed below:
Savings in monthly expense: $120 for 12 months = $1440
Plus lower loan balance in month 12: $2620
Equals total saving from refinance: $4060
Less refinance cost: $3750
Equals net gain: $310
Next think about the case where an 11% loan taken out in 1996
was for 15 years, and now has only 6 years to run, while you
plan to refinance into a 30-year loan. With the lasting term
shorter on the old loan and longer on the new one, the
difference in monthly expense rises to $1238. Using the rule of
thumb the $3750 cost would be recovered in only 3 months. But
this fail to consider the slower loan repayment on the new loan.
Taking account of the slower repayment, you do not really come
out in advance until 14 months out.
The rule of thumb (dividing the upfront cost by the decrease in
mortgage expenses) approximates the true break-even period only
if the term on your new loan is close to the unexpired term on
your old loan. In other circumstances it can lead you critically
off course.
The rules of thumb also ignore the detail that if you had not
refinanced you could have earned interest on the money you pay
upfront to refinance; and if you do refinance and the expense is
reduced, you can now take home interest on the savings.
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