The rule of thumb does not allow
for the difference in how rapidly you pay off the new loan as
opposed to the old one. Lets say that in 1992 you took out an
11% 30-year fixed rate loan, which now has a $100,000 balance
and 21 years to run. You refinance into a 7% 15-year loan at a
cost of $3,750.
Monthly payment on the old loan =
$1019
Monthly payment on the new loan =
$899
Reduction in monthly payment = $120
$3750 divided by $120 = 31 months
The rule of thumb says that you
break-even in 31 months. However, because of the shorter term
and lower rate on the new loan, in 31 months you would owe
$7,041 less than you would have owed on the old loan. So, the
rule of thumb in this case seriously overstates the break-even
period. Taking account of differences in the loan balance, you
would actually be ahead of the game in 12 months, as shown
below:
Savings in monthly payment: $120
for 12 months = $1440
Plus lower loan balance in month
12: $2620
Equals total saving from refinance:
$4060
Less refinance cost: $3750
Equals net gain: $310
Next consider the case where an 11%
loan taken out in 1992 was for 15 years, and now has only 6
years to run, while you plan to refinance into a 30-year loan.
With the remaining term shorter on the old loan and longer on
the new one, the difference in monthly payment rises to $1238.
Using the rule of thumb the $3750 cost would be recovered in
only 3 months. But this fails to consider the slower loan
repayment on the new loan. Taking account of the slower
repayment, you don't actually come out ahead until 14 months
out.
The rule of thumb (dividing the
upfront cost by the reduction in mortgage payment) approximates
the true break-even period only if the term on your new loan is
close to the unexpired term on your old loan. In other
circumstances it can lead you seriously astray.
The rule of thumb also ignores the
fact that if you had not refinanced you could have earned
interest on the money you pay upfront to refinance; and if you
do refinance and the payment is reduced, you can now earn
interest on the savings. |