Break Even Analysis Calculating A Mortgage Loan When Refinancing

Refinancing a mortgage can be a complex financial decision. Break even analysis helps determine when the savings from refinancing will cover the costs, making it a valuable tool for homeowners considering this option. This guide explains how to perform break even analysis for refinancing a mortgage loan.

What is Break Even Analysis?

Break even analysis is a financial method used to determine the point at which the total cost of refinancing equals the total savings. For mortgage refinancing, this means calculating when the money saved on interest payments will offset the closing costs and other fees associated with refinancing.

The break even point is typically expressed in months or years. If the break even point occurs within a reasonable timeframe, refinancing may be a good financial decision. If it takes much longer than the expected loan term, refinancing might not be worthwhile.

How to Calculate Break Even for Refinancing

To calculate the break even point for refinancing a mortgage, you need to consider several factors:

The current mortgage balance
The current interest rate
The new interest rate offered by the lender
The closing costs associated with refinancing
The expected loan term

Break Even Formula

The break even point (in months) can be calculated using the following formula:

Break Even Point = Closing Costs / (Monthly Savings)

Where Monthly Savings is the difference between the monthly payment of the current loan and the new loan.

Here's a step-by-step breakdown of the calculation:

Calculate the monthly payment for the current mortgage.
Calculate the monthly payment for the new mortgage offer.
Determine the monthly savings by subtracting the new monthly payment from the current monthly payment.
Divide the total closing costs by the monthly savings to find the break even point in months.

Note: This calculation assumes you will keep the loan for the full term. If you plan to sell or refinance before then, the break even point may be different.

Worked Example

Let's look at an example to illustrate how to perform break even analysis for refinancing.

Scenario

Current mortgage balance: $200,000
Current interest rate: 5.5%
Current loan term: 30 years
New interest rate: 4.5%
Closing costs: $3,000

Step 1: Calculate Current Monthly Payment

Using the standard mortgage payment formula:

M = P [i(1 + i)^n] / [(1 + i)^n - 1]

Where:

M = monthly payment
P = principal loan amount ($200,000)
i = monthly interest rate (5.5%/12 = 0.004583)
n = number of payments (30 years × 12 = 360)

Current monthly payment = $1,202.96

Step 2: Calculate New Monthly Payment

Using the same formula with the new interest rate (4.5%):

New monthly payment = $1,085.67

Step 3: Calculate Monthly Savings

Monthly savings = Current payment - New payment = $1,202.96 - $1,085.67 = $117.29

Step 4: Calculate Break Even Point

Break even point = Closing costs / Monthly savings = $3,000 / $117.29 ≈ 25.56 months

This means that it will take approximately 25.56 months (about 2 years and 1.56 months) for the savings from refinancing to cover the closing costs.

Interpretation: Since the break even point is within 2.5 years, refinancing in this scenario could be financially beneficial if you plan to stay in the home for at least that long.

Key Factors to Consider

When performing break even analysis for refinancing, consider these additional factors:

1. Property Value Appreciation

If the property value increases, the equity you gain can offset some of the refinancing costs. This can shorten the break even period.

2. Additional Costs

Factor in any additional costs such as appraisal fees, title insurance, or private mortgage insurance if applicable.

3. Interest Rate Changes

If interest rates rise after refinancing, your monthly payments may increase, potentially lengthening the break even period.

4. Loan Term

Shorter loan terms may have higher monthly payments but can result in a faster break even point.

5. Tax Benefits

Consider any potential tax benefits from refinancing, such as deducting mortgage interest or points.

Frequently Asked Questions

What is a good break even point for refinancing?: A good break even point is typically within 2-3 years. If it takes much longer, refinancing may not be financially beneficial.
How accurate is break even analysis for refinancing?: Break even analysis provides an estimate, but actual results may vary due to changing interest rates, property values, and other factors.
Should I consider refinancing if the break even point is longer than my loan term?: If the break even point exceeds your expected loan term, refinancing may not be worthwhile unless you expect significant property value appreciation.
What other factors should I consider besides break even analysis?: Consider your financial goals, the stability of interest rates, and whether you plan to sell the property soon.
Can I use this calculator for different types of refinancing?: Yes, the calculator can be used for rate-and-term refinancing, cash-out refinancing, or other types of refinancing.