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