Mortgage lenders often attract homeowners seeking to lower their mortgage interest rate with some simple math, usually presented in one of two ways:

1) Comparing the nominal closing costs to the total savings from 30 years of a lower monthly payment, or

2) How few months it will take before you break even with your refinancing closing costs due to lowering the monthly payment

Either way, the refinance looks very attractive: for a little cash up front, you can save far more money over the term of the loan. But don’t be fooled by the numbers – a lower monthly payment does not always mean saving more money, and it has little to do with the closing costs. The paradox can be explained easily by calculating the **true total cost refinancing the loan**. Let’s look at an example based on a typical refinance deal with Table 1 summarizing the key terms around the current loan and refinance offer.

**Table 1: Current and Refinance Mortgage Terms**

Looking at Table 1, the refinance offer for the lower rate of 4.47% looks like a great deal because you save $100 per month on the lower payments ($2150 – $2050). But this only paints a partial picture because it assumes that both loans are still for 30 years, whereas you have already paid off 2 years of the current loan. Here’s a breakdown of the numbers that you will see from most lenders brokers (column 1) and the numbers you really should consider (column 2):

**Table 2: Refinance Calculation Costs**

Most mortgage lenders and online refinance calculators will perform a ‘Refinance Savings’ calculation (the first column calculation in Table 2), drawing the conclusion that the **refinance looks very favorable**. After all, for just $3,000 in closing costs, you can save $33,500 over 30 years! And it would take just 30 months (or 2.5 years) to break even on closing costs, after which it’s pure savings. However, the ‘Real Cost of Refinance’ calculation (second column calculation in Table 2) shows the refinance clearly is a poor choice. Instead of saving money, you would **actually lose over $15K** over the life of the loan, even though your monthly payment is reduced. Worse, you would pay $3,000 in closing costs on top of your loss.

**Analysis**

How can both calculations provide such different results? Technically, both calculations are correct; however, the ‘Refinance Savings’ calculation (Column 1 in Table 2) does not take into account the **money you’ve already put into your current loan**, or the fact that by refinancing, you are actually extending your loan for 24 more months. What this analysis tells us is that the farther into your loan you are, the lower the refinance interest rate and monthly repayment must be to make refinancing an attractive option. Don’t get fooled by simply looking into the top line monthly repayment number.

Finally, a simple Google search for “refinance calculator” will return many links to help you assess your refinance. However, the vast majority of these links do not offer the ‘Real Cost of Refinancing’ calculation as described in this post. While you can do the above calculations through Excel following the above logic, below is a free refinance calculator I found that does it for you. Incidentally, the calculations above are a short cut for estimating the actual savings/loss related to refinancing. To perform the analysis even more accurately, you must compare the total remaining interest on the current loan to the total lifetime interest on the refinance. Those formulas are a bit more complicated, but the results will be roughly the same as using the simpler approach above.

Remember, mortgage lenders and brokers earn revenue from the refinance, whether or not you save money – it’s in their best interest to ‘sell the refinance’ to you. So it’s in your best interest to **perform the right analysis** to ensure the refinance is truly right for you.

{ 5 comments… read them below or add one }

You are not comparing apples to apples. If you amortize $406K over the 28 years left @4.47, you P&I would be $2120/mo. Even if you add in the closing costs, to get to a $209K balance, your payment would be $2136. Based off this calculation, you are still better off refinancing albeit for a $14/mo savings.

Why do you use $772,400 in the “Total Savings Over Life of Loan” calculation when the amount of $722,400 is what you calculated for “Total Cost of Remaining Loan”? In other words, should not the calculation be $738000 – $722000

Another important factor to consider is Time Value of Money. Is the money paid towards the loan the 29th and 30th year as valuable as the money you pay before the 28th year? Refinancing without unnecessary closing costs or increase in principal usually improves cash-flow and works in your favor given all currencies are subject to inflation in the long run.

This is an interesting perspective and mathematically correct. But, the lower payment may actually be beneficial for people just looking to cut their monthly expenses. $100 is a decent savings. Yes, over 30 years you pay more but refinancing does give you financial flexibility in the short term.

Great post and something few people look at.