Rule of Thumb: When Does it Make Sense to Refinance a Mortgage?

When does it make sense to refinance my mortgage loan? Is there some kind of rule of thumb to go by? That depends on your reasons for refinancing. If you’re doing it primarily to save money, you can use the rule-of-thumb explained below.

The basic formula is: Closing costs √∑ monthly savings = break even point.

When Does It Make Sense to Refinance a Mortgage?

Here’s a general rule-of-thumb that applies to most refi situations. If you can lower your interest rate and mortgage payments by refinancing, and you’ll stay in the home long enough to recover the closing costs on the new loan, then it might make sense for you to refinance.

The most common reasons for refinancing are:

  • To get a lower interest rate and reduce monthly payments
  • To shorten the repayment term of the loan
  • To switch from an adjustable to a fixed-rate loan
  • To convert home equity into cash (as in the “cash-out refinance”)

Most people who refinance their mortgage loans do it for the fist reason on this list. They do it to save money by securing a lower interest rate. If this is your goal, you must ensure you will stay in the home (and keep the new loan) long enough to recoup your refinancing costs.

Related: Can FHA loans be refinanced?

The Rule-of-Thumb in Action

Here’s an example of the when to refinance rule-of-thumb in action.

John and Jane apply for refinancing to get a lower rate on their mortgage loan. The lender tells them they qualify for a 5.5% interest rate. This is lower than their current rate of 6.5%. So, at first glance, the refi seems to make sense. The couple will lower their monthly payments by reducing the amount of interest they’re paying.

So they should move forward with the deal, right? Not yet. They haven’t looked at the second part of the rule-of-thumb. They’ll need to stay in the home long enough to recoup the money they spent to refinance.

Let’s say that their total closing costs on the new loan come to $3,800. By getting a lower rate on the new loan, they’ll save money with a smaller payment each month. But they have to carry those savings long enough to surpass the $3,800 they paid out of pocket in closing costs.

If they keep the mortgage for many more years, they’ll eventually accomplish this. But if they turn around and sell the home in a few years, their accumulated savings would be less than what they paid in closing costs.

In other words, if they sell the home too soon, they won’t even reach the break-even point (much less achieve any long-term savings).

Calculating the Break-Even Point

The break-even point (BEP) is one of the most important concepts in mortgage refinance, particularly if your primary goal is to save money in the long term. This is the point beyond which your accumulated savings will begin to exceed your closing costs. By calculating the BEP, you’ll know when it makes sense to refinance your home — and when it doesn’t make sense.

Fortunately, the math is simple. Let’s revisit John and Jane, our hypothetical homeowners from earlier. They found out they would have to pay $3,800 in closing costs. Their lender says they’ll save $100 per month after refinancing, by getting a lower rate. Now they’re ready to calculate the break-even-point to determine if it makes sense to refinance.

Here are the steps they would take:

  1. Determine the total cost of refinancing ($3,800 in this case).
  2. Determine the amount saved each month after refinancing ($100 per month).
  3. Divide the cost of refinancing by the monthly savings (3,800 / 100 = 38).

The break-even point in this scenario is 38 months. After 38 months, the couple’s accumulated savings (from having a lower rate) would begin to surpass¬†the amount they paid in closing costs and fees.

So there’s your formula: Closing costs divided by monthly savings equals break-even point.

Now they can answer the question: When does it make sense to refinance? If saving money is the primary reason why John and Jane are refinancing, they should plan to stay in the home and keep the new loan for at least 38 months. If they sell or refinance before 38 months, they’ll end up losing money on the refi deal. That’s the general rule-of-thumb for refinancing success.

Disclaimer: Your mortgage situation might differ from the generalized example provided above. This article contains a general rule-of-thumb homeowners can use when considering a refinance loan. It may not apply to all lending scenarios. Ask your mortgage lender for a complete breakdown of costs versus savings, so you can make an informed decision.