It is worth it when leaving costs less than staying, measured over the same period. Staying costs the remaining payments on the current debt. Leaving costs the prepayment penalty, the new loan's fees and closing costs, and the payments on the new loan, plus whatever balance it still carries at the end of the period. If leaving costs less by the date you expect to sell, refinance again or pay off the debt, the refinance saves money. A longer term can cut the monthly payment sharply while increasing total cost, so test both answers separately.
- Cost of staying
- Remaining payments on the current debt
- Cost of leaving
- Prepayment penalty, fees, closing costs, new payments, and any balance left
- Compare over
- The same period, ending when you expect to sell, refinance or repay
- Lower payment
- Comes mostly from a longer term; can raise total cost
- Lower total cost
- Comes from a lower rate, and only after the upfront costs are recovered
- SBA refinance test
- The new payment at least 10% lower than the debt it replaces
Two different questions
Owners usually come to a refinance with one of two goals. Some need a lower payment: the business is profitable but the debt service is squeezing working capital, or a covenant is getting tight. Others want a lower total cost: rates have come down, or the business has grown into a better credit, and they want to pay less interest. Both are legitimate. They are not the same calculation, and a refinance that answers one can fail the other.
The payment is mostly a function of the term. Stretching the same balance over more years lowers each payment whether or not the rate improves. Total cost is mostly a function of the rate and the time the money is outstanding. A longer term keeps the balance outstanding longer, so it adds interest even at a lower rate. See loan term vs amortization period and interest-only periods and re-amortization.
A lower monthly payment is not evidence that a refinance saves money. It is evidence that the balance is being repaid more slowly.
The break-even, step by step
Pick a horizon first: the date you expect to sell the business, refinance again, or repay the debt. Every figure below is measured to that date, because a saving that arrives after the business is sold is not a saving to you.
- 1. Cost of staying. Add up the payments left on the current debt through the horizon. If the debt runs past the horizon, add the balance still owed on that date, because you will pay it then.
- 2. Cost of getting out. Get the payoff: principal, accrued interest, the prepayment premium and any swap termination. The premium and any exit fees are the part that counts as cost. See how prepayment penalties work and payoff letters.
- 3. Cost of getting in. The new lender's origination fee, legal fees on both sides, appraisals, lien searches and filings, and on an SBA loan the guaranty fee. Whether these are paid in cash or added to the loan, they are cost; added to the loan, they also carry interest.
- 4. Cost of the new debt. Add up the new loan's payments through the horizon, plus its balance on that date, plus its own prepayment charge if you will repay it then.
- 5. Compare. If steps 2 to 4 together come to less than step 1, the refinance saves money over your horizon. The difference is the saving.
The shortcut many owners use is to divide the upfront costs by the monthly saving and call the result the break-even. It is a reasonable first screen when the new loan has the same remaining term as the old one, provided the saving counted is the interest saved, not the payment difference. Once the term changes, the shortcut gives the wrong answer, because a smaller payment on a longer loan is partly principal you have not repaid yet.
A worked example
A business owes 1,000 with four years left, at a rate of 10 per 100 a year, paying about 315 a year. Refinancing costs 50, paid in cash at closing: a prepayment premium of 20, the new lender's origination charge of 15 and closing costs of 15. The new loan is 1,000, the same as the payoff. A new lender offers 8 per 100, either over the same four years or stretched to seven. For simplicity, payments are annual.
| Stay | Refinance, same four years | Refinance, stretched to seven years | |
|---|---|---|---|
| Annual payment | 315 | 302 | 192 |
| Payment saving each year | 13 | 123 | |
| Interest over the life of the loan | 262 | 208 | 345 |
| Upfront costs | 0 | 50 | 50 |
| Interest plus upfront costs | 262 | 258 | 395 |
| Paid over four years, plus balance still owed | 1,262 | 1,258 | 1,313 |
The same-term refinance barely clears. The lower rate saves 20 of interest in year one, about 16 in year two, about 12 in year three and about 6 in year four, because the balance shrinks. The 50 of costs is only recovered in the fourth year. Over the full term it saves about 4. If the owner sells the business in year three and the loan is repaid at the sale, the refinance lost money. The simple shortcut, 50 divided by the first year's saving of 20, would have said two and a half years.
The stretched refinance cuts the payment by 123 a year, which may be exactly what the business needs. But it costs about 133 more in interest and fees over its life, and at the end of year four the owner has paid 818 including costs and still owes 495. On every measure of total cost it is worse than staying, even at a lower rate.
Neither result makes the stretched loan wrong. It makes it a purchase of cash-flow relief at a known price, and the owner should know the price before signing.
When the lower payment is the right answer
There are good reasons to pay more in total for a lower payment.
- Coverage. A business whose earnings cover its debt service thinly is one bad quarter from a covenant breach. Conventional bank lenders commonly look for debt service coverage of at least 1.25x; a refinance that moves the business back above that line is buying time and stability. See debt service coverage and covenant breach options.
- Expensive short-term debt. When the debt being replaced is a stack of cash advances or high-cost short notes, the payment reduction is large enough that the total-cost comparison usually favors the refinance as well. See refinancing cash advances into term debt and consolidating business debt.
- A balloon coming due. If the current loan matures with a large balance the business cannot pay, the comparison is not stay or leave; it is refinance now or refinance under pressure later. See refinancing ahead of a balloon.
- Better uses for the cash. If freed-up cash earns more in the business than the new loan costs, the longer term pays for itself. That is a real argument only when the use is specific.
- Flexibility. A longer loan with no prepayment penalty lets the business pay extra principal in good years and the scheduled amount in lean ones. It combines the low payment with the option of the low total cost, provided the business actually makes the extra payments.
An SBA refinance builds the payment question into the rules: refinancing existing debt with a 7(a) loan requires the new payment to be at least 10% lower, and the debt current for the last 12 months. See refinancing existing debt with a 7(a) loan.
What the arithmetic leaves out
A break-even table compares the cash. Several things that matter to an owner sit outside it, and some of them can decide the question on their own.
- Fixed or floating. Comparing a fixed rate with a floating one assumes a path for rates. Run the floating option at a higher rate as well as today's. See fixed vs variable rate.
- The new loan's exit terms. A refinance into a loan with heavy call protection saves on paper and locks the business in. If a sale is likely inside the protection period, price it in.
- Guarantees and collateral. A refinance that releases a lien on the owner's house or limits a personal guarantee has value no payment table shows. See releasing a personal guarantee in a refinance.
- Covenants. A cheaper loan with tight covenants can cost more in practice than a dearer one with room. See covenant headroom.
- Every cost in the offer. Unused-line fees, required deposit balances and hedging requirements change the effective rate. See interest rate vs all-in cost.
Getting the real numbers
The break-even is only as good as its inputs. The current side needs a written payoff letter, including the premium and any swap termination, and the existing notes, so the remaining schedule is right. The new side needs term sheets priced on the same basis, with every fee listed. Start with a debt schedule showing each debt's balance, rate, payment, maturity and prepayment terms.
A lender then needs the file the new loan will be underwritten on. For a conventional term loan, Transparent's checklist is the P&L, a year-to-date P&L through last month-end, the balance sheet and the debt schedule; for an SBA refinance, add two to three years of business and personal tax returns, a personal financial statement for each owner of 20% or more, and copies of the notes being refinanced. Transparent's financing model runs the stay and leave cases side by side, over the owner's horizon, with the exit cost of the new debt included; see the lender package and how we underwrite.
Common questions
- What is a simple rule of thumb for the refinance break-even?
- Divide the upfront costs, including any prepayment penalty, by the interest saved in the first year. That gives a rough payback period, but only when the new loan has the same remaining term. Because interest savings shrink as the balance falls, the true payback is longer than the shortcut shows.
- Does a longer term always cost more in total?
- At the same rate, yes, because the balance stays outstanding longer. At a lower rate it can go either way, depending on the size of the rate cut and how much the term is stretched. Calculate it rather than assuming.
- Should I include the prepayment penalty on the new loan?
- Yes, if you expect to repay the new loan before it matures, for example on a sale. The cost of leaving the new loan belongs in the comparison on the same basis as the cost of leaving the old one.
- Is it worth refinancing to lower payments if it costs more overall?
- It can be, when the lower payment restores debt service coverage, heads off a covenant breach or replaces expensive short-term debt. The point is to know the price of that relief before signing, not to avoid it.
- How much lower does my payment need to be for an SBA refinance?
- Refinancing existing debt with a 7(a) loan requires the new payment to be at least 10% lower than the payments on the debt being replaced, and that debt must have been current for the last 12 months.