As you start thinking about refinancing, you need to understand the following two concepts in order to make a financially sensible decision.

1. Return on investment

2. Payback period

Let’s dive deeper into definitions and understand better with illustrative examples.

Return on Investment

When you are refinancing a mortgage, you are investing money to get reasonable returns. For example, closing costs are investments to save in interest, which is the ultimate return. Return on Investment (ROI) is a performance measure to determine the amount of return on a particular investment relative to the investment costs.

Thankfully, it is relatively easy to calculate the refinance ROI. Take the benefits or savings you have when you refinance and then divide it by the cost of refinance. The result is expressed as a percentage or a ratio.

For example, if:

S is the savings due to refinancing and  C is the cost of refinancing, then

ROI = S/C expresses as a %.

Let’s apply that to real world numbers. Say you have a $300,000 mortgage at 6% interest rate for 30 years. Over the loan period, you would be paying a total interest of $347,514.57 over 360 payments before fully paying off the mortgage. You are five years into the mortgage, and you found a mortgage lender offering you 4.8% for a 30-year loan. Should you refinance?

After 5 years (60 payments) you have paid $87,082.16 in interest and have a remaining balance of $279.163.07 still to be paid off. Also, if you continue to be on the same mortgage, you will still have to pay $260,432.40 in interest for the remaining period of the loan.

Scenario 1: Refinance for another 30 years

Let’s explore the case where you refinance the remaining $279,163.07 at the new interest rate of 4.8% for another 30 years. You will pay a total interest of $248,118.82, in addition to the closing cost of $11,166.52 (estimated at 4% of the cost of the house).

So, what it the ROI?

Savings = ($260.432.40 — $248,118.82) = $12,313.58 Cost = $11,166.52 ROI = 12,313.58/11,165.52 = 1.1%

While the ROI is positive, this may not be worth the effort and maybe it would be better to wait for the interest rate to go down further or go for a 15-year mortgage.

Scenario 2: Refinance for another 15 years

Let’s explore the 15-year mortgage option.

Now for the same remaining balance of $279,163.07, the total interest would be $112,990.13 for a 15 year.

Savings = ($260,432.40-$112,990.13) = $147,442.27 Costs = $11,166.52 ROI = $147,442.27/$11,166.52 = 13.20%

Now we are talking! Reducing the mortgage period (from 30 years to 15 years) reduces the total interest paid and gives you a much higher ROI percentage in this scenario. Please keep in mind that reducing the mortgage period often results in higher monthly payments. For this case, the monthly payment is now $2178.63 with the 15-year loan compared to the $1464.67 for the 30-year loan. Depending on what your primary objectives are, this may or may not be desirable.

While ROI is a good, general indicator, refinancing decisions must consider all your factors. Key things to keep in mind:

1. ROI is net positive when you save more money than you spend through refinancing. Negative ROI should be avoided.

2. By comparing the ROIs of different refinancing options (different lenders, for example） you can compare the benefits and make the best choice for yourself.

Payback period

This second concept refers to the amount of time it would take for you to recover the cost of investment (closing costs, for example). To calculate the exact payback period, you can divide the amount of the investment by the annual cash flow.

For example, if:

S is the savings per year, C is the cost of refinancing then

Payback Period = C/S

Let’s say the cost of refinancing is $12,000 and you would save $200 each month ($2,400 annually). If so, your payback period will be 5 years since $12,000/$2,400 = 5.

Jumping back to previous examples from above:

Scenario 1: Refinance for another 30 years

Refinancing at 4.8% for 30 years, your savings per year would be $410.45 and thus your payback period would be $11,166.52/$410.45 = 27 years! Probably not the best idea.

Scenario 2: Refinance for another 15 years

Refinancing at 4.8% for 15 years, your savings per year would be $9,829.48 and thus your payback period would be $11,166.52/$9,829.48 = 1.14 years.

Key things to keep in mind:

1. Because you recover the investment costs quicker, shorter payback periods are more attractive than longer ones.

2. Payback periods disregard the time value of money (opportunity cost). What other opportunities you could have pursued with the savings, their potential returns, inflation rates are some things to consider.

Payback period vs. Breakeven point

While these two terms are related, they are not the same. Breakeven point is when the savings cover the costs of the investment, and the payback period refers to how long it would take for you to reach breakeven.

Conclusion

In summary, return on investment (ROI) and payback periods are good indicators to evaluate options and see if refinancing would make sense. However, it is important to remember that making a refinancing decision is not just about saving money — your situation and personal goals are equally important factors that could influence your decision. To ensure you have the latest and most accurate information, please talk to a financial advisor to strategize a plan that makes the most sense to you.