Should I Refinance? Completing a Break-even Analysis

Last week, in my post Lessons Learned:  Financing My First Home, I wrote about buying my first home and the financing process behind obtaining it.  I mentioned briefly that you should do a break-even analysis anytime you are thinking of refinancing.  This could be a mortgage loan refinance, or something else like student loans or an auto loan.  What’s the best way to go about figuring out if the refinance is viable and the best choice?

As an accountant, I like to do this in a spreadsheet.  I have added the Excel file shown within this post to my new Templates page, where I intend to share my tools that you can use to become savvier. 

There are different scenarios to look at when doing a break-even analysis.  First, in a refinance, you shouldn’t consider “sunk costs” or money you have already spent on interest.  That’s because you have spent it and will not save anything in the future.  Let’s imagine you were thinking about refinancing from a 30 to a 15 year mortgage with the objective of paying less interest and owning your home free and clear, sooner.  Imagine the interest rate you have on your 30 year is 3.625% and the new rate would be 3.125% on a 15 year.  Also, let’s say you are three years (36 months) into paying your 30 year mortgage, so all the interest you have paid at the higher rate is a sunk cost.  According to my spreadsheet, you have paid interest of $27,804 (note: for this exercise, I am rounding to the nearest dollar).  This point is important because you will want to start at your current ending balance for the refinance, or $247,625.

Loan amortization schedule snapshots by W. Vance

Next, copy the tab and use your current ending balance for the refinance, or $247,625, as the loan amount.  If your loan officer tells you there is no “out-of-pocket” costs, you will need to add in the closing costs from your good faith estimate.  Let’s assume the costs to refinance come to $3,500.  This will need to be added in as your loan balance will increase, for a new loan balance of $251,125.  Change the interest rate to 3.125% and the term to 15 years.

Loan amortization schedule snapshots by W. Vance

You can already see you would save BIG by making this move if you take the total interest of the 30 year loan, less interest already paid, less interest that would be paid on the 15 year, less closing costs ($142,486-$27,804-$43,170-$3,500=$68,012).  This savings is if you assume you stay in the home for the next 15 years and would have paid the minimums on the 30 year mortgage. 

So, where is the break-even in all this? 

This part is where the Excel spreadsheet makes it easy to spot about when you will hit that magical point in time where you are profitable in your refinance.  To do this, I went back to the original, 30 year tab and added columns for the cumulative interest from the refi-point (December 01, 2017 in this case) and linked the cell for cumulative interest from the 15 year tab.  Then, I added in a difference tab (30 year cumulative interest, minus 15 year cumulative interest), and followed the total down until it was close to $3,500 in closing costs.  In this case, in month 31, or two years and seven months into the schedule, I would break-even on my refinance.

Loan amortization schedule snapshots by W. Vance

So, this seems like a lot of numbers and does it really matter?  I mean, a lower rate is always better, right? 

Not always!  Let’s say you started paying your 30 year like a 15 year.  Then your break-even would be much further down the road.  In this case, by not refinancing, you save the $3,500, but pay your old, slightly higher rate.  This means it takes even longer to break-even, which is at month 41, or about three and a half years.

Loan amortization schedule snapshots by W. Vance

Let’s imagine that I wanted to move to a new home and sell this one within the next three years.  Then it would be a bad move to refinance, because I wouldn’t recoup my closing costs with interest savings.  Doing nothing is better in this scenario.

Other Considerations besides savings and break-even points

Sometimes saving on interest looks good on paper, but may be more difficult to execute in real-life.  If you have seen a good increase in income since purchasing your home, and other goals are complete or well underway, then refinancing to save interest over the years may be a great move.  However, if you still need to build up emergency cash, kid’s college savings, or have consumer debt, you should hold steady and divert extra cash to those goals.  Also be careful that a higher mortgage payment doesn’t drive you into debt in other areas such as using credit cards to make up for the cash being spent on the house.  This defeats the whole purpose of a refinance and likely has you paying more interest because of the credit cards.  Only refinance if it saves you a considerable amount of interest and beware the temptation to fall for those ads to refinance and take cash out or lower your payment by resetting the amortization clock on your loan.  If you have 20 years left, and find rates have dropped, make sure you request a 20 year term and not a 30.  No one wants to be paying for their home long after their retirement, or worse yet, can’t retire because they took out a 30 year mortgage at age 55! 

Did I completely overwhelm you with all these calculations?  Don’t feel discouraged!  I’m an accountant and sometimes get carried away.  Send me a comment on your situation and I’m willing to help!