The saying goes, "It costs money to make money." This is true with refinance loans. Although securing a lower interest rate will definitely save you money, you have to pay closing costs to set up the loan. Whether you pay them up front (recommended) or roll them into the loan balance, closing costs represent real money you have to pay—just like a lower interest rate represents real money you save. They are two sides of the refi coin.

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The breakeven point of a mortgage refinance is when the true savings start. From the first day, you are happily saving money every month with a new, lower payment, but don't forget that your wallet is lighter because of closing costs. There was a price to pay to get the ball rolling. It will take some time before the savings cover the cost. When you reach that time, you break even.

Calculating the breakeven point of your refinance not only brings the real savings and costs into sharper focus for yourself but can also help you decide whether the refi is worth pursuing in the first place. So how do you calculate the breakeven point of a refi?

Breakeven Point = Closing Costs ÷ Monthly Savings

The formula looks simple, but closing costs aren't always what they seem. If you pay them up front, you pay face value. However, if you choose to roll them into the loan amount, they could end up costing you 25%-50% more. Let's look at the difference.

Closing costs paid up front vs. rolled into loan.

Some closing costs are negotiable, while others are fixed. Most of them are transaction fees established by the lender itself, and some are third-party fees. Unlike interest rates, which may vary only a fraction of a percentage point from lender to lender, the swing in closing costs is wide, from 2% to 5% on average. Total closing costs in the United States averaged $5,749 last year, including taxes.

To save the most you can during a refinance, your goal should be to pay closing costs up front. The alternative is to roll the closing costs into the loan balance, but then you pay interest on them and could end up paying 25%-50% more for them depending on the length of the loan.

Here is an example. Let's say you refinance for $200,000 and the closing costs are $7,200. Your new loan is a 15-year fixed-rate mortgage. You have the choice of paying the closing costs out of pocket, which keeps the loan amount at $200,000, or rolling them into the loan, which increases the amount to $207,200.

Interest Paid Over 15 Years With & Without Closing Costs
BASE LOAN	INT. RATE	CLOSING	TOTAL LOAN	MO. PYMT	TOTAL INTEREST
$200,000	4.5%	Cash up front	$200,000	$1,530	$75,398
$200,000	4.5%	$7,200	$207,200	$1,585	$78,112

If you choose to roll the closing costs into the loan, each payment increases $55 for 15 years and, in the end, you will have paid an extra $2,714 in interest on the $7,200 closing costs. That means you paid 38% more for closing costs compared to cash up front.

Determine your actual closing costs.

For the first variable in the formula, the closing costs, you would use one of these two numbers.

Face value: Closing costs as shown on the Closing Disclosure, a document the lender gives you toward the end of the process. Because you're paying them now with cash, the costs are exactly as they appear. Be warned that final costs can vary from what you saw earlier in the loan estimate. To avoid surprises, always ask for the most complete listing possible of closing costs in the estimates you get from all lenders.
Financed value: What the closing costs actually cost you in the end because they were tacked onto the loan. To determine this, enter your original loan amount and interest rate into an amortization schedule (Excel has a free template) or one of many online calculators. Make note of the total interest you would pay. Now increase the loan amount by the closing costs, and make note of that total interest; it will be higher. The difference between the two interest amounts is the extra you'd pay to finance the closing costs, so add it to the closing costs to get their financed value.

Divide the closing costs by how much you save with the new, lower monthly payment.

This part of the formula is straightforward. We answer the question, "If I save X-number of dollars every month, how long will it take for me to recoup the closing costs?"

For example, if your old mortgage payment was $1,300 and the new one $1,075, the savings is $225 per month. Let's say you paid the closing costs of $6,000 in cash. The breakeven point comes just before 27 months:

Breakeven Point = Closing Costs ÷ Monthly Savings
26.6 = $6,000 ÷ $225

What Is a Good Breakeven Point?

Is 26.6 months a good number? Yes, according to money expert Clark Howard, among others. Howard draws the line at 30 months. You want to be free to refinance in three or four years. At that time, you don't want to be in the payback period of the previous refinance still, having not realized any actual savings yet. To go from loan to loan without reaching the breakeven point is just treading water and giving yourself hassles.

A breakeven point beyond 30 months probably indicates that the refinance is a better deal for the lender than for you. The lender would be making a lot of money off such a loan—so much money that you won't even break even after 30 months.

Going back to our example, what if you rolled the $6,000 closing costs into the loan? The first repercussion is that your monthly payment grows a bit. Let's say that your savings decreases from $225 to $205. With the aid of a loan amortization schedule, we determine that raising the loan amount by $6,000 would cost an extra, say, $1,500 in cumulative interest. The financed value of the costs is therefore $7,500. How long will it take a monthly savings of $205 to pay back $7,500?

Breakeven Point = Closing Costs ÷ Monthly Savings
35.1 = $7,500 ÷ $205

This breakeven point is way over the threshold of 30 months. The jump from 26.6 months to 35.1 was entirely because of the choice to finance the closing costs, making it obvious that the only party benefiting from the jump is the bank.

Borrowers all have their own personal priorities. You could draw the line at 28 months or 32, but the point is to know the breakeven point of every potential loan so you can make fully informed financial choices. You want to save money from the deal sooner rather than later. When you make that first new, lower payment, you may feel like the savings have begun, but factoring in the closing costs will shine a light on the truth. Only at the breakeven point do you really start saving money.

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Recap

The breakeven point is the time in a loan when the monthly savings have offset the closing costs.
Earlier breakeven points mean those loans are better for you, helping you compare offers.
True saving doesn't start until the breakeven point.

Refi Breakeven Point: How to Calculate Yours

A mortgage refinance takes money in the form of closing costs, so when does the saving start?