When does refinancing make sense? Break-even points and the reset-the-clock trap

Refinancing a mortgage means replacing your current loan with a new one, usually at a different interest rate, a different term, or both. It can save a lot of money, but it isn't free, and a lower monthly payment doesn't automatically mean you come out ahead. The key concept is the break-even point.

The costs of refinancing

A refinance is a new mortgage, so it comes with closing costs: an appraisal, title insurance, lender fees, recording fees, and so on. These commonly add up to a few percent of the loan amount. Those costs are the price you pay up front for a lower rate, and the savings need to repay them before you're actually ahead.

Calculating the break-even point

The break-even point is the closing costs divided by the monthly savings. Suppose you owe $300,000 at 7% with 28 years left, paying about $2,039 a month in principal and interest. You're offered a new 30-year loan at 6%, with $6,000 in closing costs.

• The new payment would be about $1,799, saving about $240 a month.
• $6,000 divided by $240 is 25 months.

If you stay in the home and keep the loan for more than about two years, the refinance pays for itself. If you might sell or refinance again before that, it probably doesn't.

Watch out for resetting the clock

Monthly savings aren't the whole story. In the example above, the new loan has 30 years while the old one had only 28 years left. Part of the lower payment comes from stretching the loan out over two extra years.

It still works out well in that case, saving roughly $31,500 in interest over the life of the loan once closing costs are counted. But consider a smaller rate cut. Refinancing $300,000 from 6.5% with 25 years left into a new 30-year loan at 6.25% lowers the payment by about $178 a month, with a break-even of about 29 months on $5,000 in costs. Yet over the full term you'd pay roughly $62,000 more in total, because the five extra years of interest outweigh the small rate reduction.

The fix is simple: compare against a new term close to your remaining term, or keep making payments at your old amount on the new loan. Going back to the first example, choosing a 28-year term gives a smaller monthly saving of about $193, a 32-month break-even, and about $59,000 in lifetime savings.

When refinancing tends to make sense

• Rates have dropped meaningfully since you got your loan. A common rule of thumb is about three-quarters of a point to a full point, but the break-even math matters more than any rule.
• You'll stay long enough to pass the break-even point comfortably.
• You want a shorter term, such as switching from 30 years to 15, to pay much less interest in total.
• Your credit has improved a lot since you first borrowed, which may qualify you for a better rate.
• You can drop mortgage insurance because your home's value has risen enough to give you 20% equity.

When it may not

If you're planning to move soon, if the rate reduction is small, or if a new 30-year loan would push your payoff date far into the future, refinancing may cost more than it saves. Cash-out refinances, which borrow more than you owe and give you the difference, are a separate decision: you're taking on more debt, and the question is whether that borrowing is worth it.

Run the numbers

The refinance calculator shows your new payment, monthly savings, break-even point, and the lifetime difference including closing costs. Try a few different terms to see how much of the saving comes from the rate and how much from simply stretching the loan out.