Should I Refinance? (Part 2)

This is part 2 of should I refinance.  Click here for part 1.  In part 1 we discuss how there are two primary ways to consider refinancing.  The first is what I call the "Pure Finance" way and the second is the "Break-Even Analysis" way.  In this article, we focus on the Break-Evan Analysis way.

Should I Refinance? Break-Even Analysis

The Break-Even Analysis way of deciding if you should refinance is simply how much am I saving each month vs how much it cost to refinance.  You divide the cost by the savings and that gives you the amount of time it would take to "recoup" the expense of refinancing your loan.  To make this calculation simple we have an example using the calculator to the right.  Your current loan details are as follows;

  1. loan balance is $145,000;
  2. an interest rate is 3.5%;
  3. the loan was originally 15 years and you have made payments for 5 years (i.e. you have 10 years remaining); and
  4. the monthly payment is $1,036.58.

The loan you are contemplating refinancing into has the following details;

  1. the same loan balance as your current loan;
  2. the interest rate is 2.75%;
  3. the term is 15 years;
  4. the monthly payment is $984.00 (a monthly savings of $52.58); and
  5. the cost to refinance is $1,000.

Using the calculator to the right we would enter the appropriate details.  To calculate the number of years left on the current loan you would take the number of months remaining and divide by 12.  For example 120 months divided by 12 equals 10 years.  Another example would be 130 months divided by 12 equals 10.83 years.

The key number in the calculation to look at is months to recoup costs.  This is also referred to months to break even.  In our example it is 19.02.  What this says is it would take us 19.02 months to recoup the $1,000 in total cost.  From there on we would accumulate savings. There is no strict rule that says you should recoup your costs in a given time.  The general rule of thumb that I've heard recommended is 3 to 7 years.  This general recommendation is good but to make it great we need to do one more step.

To make a real informed decision you need to perform one more step.  You will notice there is a line that says difference in interest.  In our case it is -$5,058.84. This occurs because we are extending the term from 10 years to 15 years.  If this was a positive number our analysis would be complete and we would refinance. 

However its not.  So what we need to do is perform the following steps;

  1. look at how many years the original loan had remaining (in our example it was 10 years or 120 months);
  2.   subtract 19.02 (our break even figure) from 120.  The result is 100.98.  That is how many months of savings we will have relative to our old payment; 
  3. take the 100.98 and multiply it by our monthly savings ($52.58) to equal $5,309.52; and
  4. take the $5,309.52 and add (-$5,058.84) equaling $250.68.  
  5. If you take cash out in your refinance or wrap the costs of the loan into the balance (i.e. the new loan starting balance is greater than the existing principal remaining) then you also have to subtract that amount (in our case it was $0) This is the total amount we gain over the life of the loan if we were to refinance. 

Based on this example, these steps result in a positive number and you should refinance.  That is if you believe it is worth the time you have to put into the refinance.

There are many caveats that occur to each persons situation.  Please seek help from a financial professional before making your decision.  If this article helped you, it most likely can help someone you know.  Please make sure to share. 

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