The Refinance Break Even Point - When Will You Save?

The cash savings from refinancing comes with a catch. You will have to pay for loan fees when acquiring the new loan. In order to get a rough idea how long it will take to recover the loan fees, people use the 2 percent rule.

The 2% Rule for an Estimate
The greater the difference between your present interest rate and the new interest rate, the faster you will recover the refinancing loan fees. If the difference is around 2% you will likely recover the cost of loan fees within 2 years. When the difference is less than 2% you will still recover your money, but it will take longer. So if you are planning on selling your house in the next year, then refinancing would not make sense, since you will not be able to recover your fees from the money saved in monthly payments. The 2% Rule can be used as an estimate, however it is better to calculate specifically how long before your savings exceed the amount spent on fees.

How Long Before You Save?
The biggest question with refinancing is -how long before I save money? Let's say your current monthly payment is $1,600, and you can refinance and reduce your monthly payment to $1,350, but it will cost $4,000 in fees. Your monthly savings is $250, however this is pre-tax savings, to see how long before you save money, you need to consider the post-tax savings. Let's assume that you fall into the 28% tax bracket. Then the amount of post tax savings is $180 per month. Now to see how many months it will take to recover the loan fees, we divide the refinancing cost by the savings per month to get the number of months before you recover the loan fees.

Months to Recover Loan Fees = Refinancing Cost / Post Tax Savings

So for our example:

Months to Recover Loan Fees = $4,000 / $180 = 22.2 months

So in our example it will take a little less than 2 years to recover the cost of refinancing. The refinance will be worth it, if you plan to stay in your house longer than 22.2 months. In our example we only took federal income tax into account, however in some states, state income tax can also be substantial. The overall procedure is the same though, find the post-tax monthly savings, then divide the refinancing costs by the post-tax monthly savings to get the number of months to recover the loan fees.

Refinancing can save you money, however the break even point is important, especially if you are planning on selling your house and moving. Make sure you know about the break even point before committing to a refinance.

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