Last article we continued our discussion on mortgages when we went over refinancing. When all the posts in the series are complete, you should have an understanding of mortgage types, structure, rates, points, fees, mortgage insurance, and refinancing. This week we are going over the break-even point.
- 1 – Common Types of Mortgages
- 2 – Mortgage Structure, What is PITI?
- 3 – Interest Rate vs APR
- 4 – Origination Fees and Closing Costs
- 5 – Discount Points
- 6 – Private Mortgage Insurance (PMI)
- 7 – Refinancing
- 8 – Break-Even Point (BEP)
What is the Break-Even Point (BEP)?
Strictly speaking, the Break-Even Point (BEP) is when all costs are equal to revenue gained. So when refinancing, the BEP is when the money you save every month on payments has paid for how much you spent to refinance the home. So how do we use this to figure out if we should refinance? Let’s take a look at some basic examples:
When the money you save every month equals how much you spent to refinance, you’ve reached the Break-Even Point.
Let’s say that it is going to cost you $3,000 to refinance your mortgage. The refi is going to save you $75 a month in interest charges. What you need to do is divide the cost by the savings. 3,000/75 = 40. So this means it’s going to take 40 months before the money you spent to refinance today is recouped from the monthly savings on interest.
Now let’s step it up a bit. If you remember, 1 discount point costs 1%. So if you are refinancing into a $150,000 mortgage and they offer you 1 discount point, you will have to pay $1,500 up front. (150,000x.01 = 1,500). For the sake of argument we’ll say it lowers your mortgage payment by $30 a month. So 1,500/30 = 50. So it’s going to take 50 months to recoup the cost of the discount point.
Let’s say you had a $250,000 mortgage at 4% on a 30 year loan. You were paying $1,194 a month (plus escrow but we’re just looking at the mortgage payment). You’ve been making payments and even putting extra on principle for the last 10 years. You have an option to refinance to a $150,000 mortgage at 4.5%, but the lender offers you 2 discount points to get it down to 4%. For the sake of easy math we are going to say that the fees for refinancing is $500. We are also going to say that the balance left on your interest payments is $70,000. The 2 discount points will cost $3,000 (150,000X.01 = 1,500 : 2 points = $3,000). So we know that in total we are going to pay $3,500 at closing. You are trying to decide on a 20 year (putting you on track for the original 30 years), or a 15 year to pay it off even sooner. Let’s run the numbers:
Option 1: 20 Year Mortgage
On a 20 year mortgage, your new payment is going to be $909 per month. Your new interest balance is going to be $68,153. So we know that we are going to save $1,847 over the life of the loan on interest payments. We also know that we are saving $285 a month on the mortgage payments. $3,500/$285 = 12.3 months. So we know that in the next year, we will recoup the cost of refinancing. So let’s take it a step further and multiply the $285 per month by the remaining 227 months and we have $64,695. Add the $1,847 in interest savings and you will have $66,542 of cash available for other things over the life of the loan!
Option 2: 15 Year Mortgage
With the 15 year mortgage, our new monthly payment is going to be $1,110 per month. Your new interest balance is going to be $49,716. We know we will save $20,284 over the life of the loan on interest payments. With this option, we are only going to save $84 per month on mortgage payments. $3,500/$84 = 41.7 months. So we know that in 3 and a half years we will recoup the cost of refinancing. Now let’s take that $84 and multiply by the remaining 138 months to get $11,592. We also need to consider that we are going to have a mortgage for 5 less years, so multiply the $1,110 per month by 60 months (5 years) to get $66,600. Add it all together: Monthly cash after BEP ($11,592) + interest savings ($20,284) + 5 years of no mortgage payments ($66,600) = $98,476 of cash freed up at the end of 20 years!
Final Thoughts: Situation Matters
So looking at the numbers, the 15 year mortgage looks really enticing. But keep in mind that this only works if you are going to stay in the house for 20 years. Let’s say you know you will be moved to another location for your job in 3 years, then the 15 year mortgage will actually hurt you. However, if you plan on staying in the home for over 10 years, the 15 year mortgage will overtake the 20 year in the savings and building of your equity in the home. So obviously the situation matters. It’s easy to get lost in the numbers and see dollar signs. But you need to look at your situation and how long you plan on staying in the home. If you will not ride out the life of the loan, then the lower monthly payment may be a better option for you. And as I’ve said throughout this entire series, ALWAYS consult a financial advisor and talk to an experienced loan officer before make a decision!