There are lots of reasons you might want to refinance, but most people fit into one (or more) of the basic four categories. Most people want to reduce their monthly payments; some want to consolidate outstanding debt, such as combining a first and second mortgage into a new first mortgage; some want to tap built-up equity in their homes, and some just want to get out of a mortgage product that they don't like, or that's costing too much — going from an ARM to a fixed rate mortgage, for example.

Whatever group or groups you fit with, there are certain rules that you must follow to reach the goal desired. Straying from some of these basics can end up not only costing time, but could end up costing more money in the future.

Why refinance?

• To Get a Lower-Interest-Rate Mortgage
  One of the main reasons homeowners refinance their mortgages is to take advantage of lower interest rates. For example, suppose you have a fixed-rate mortgage, but interest rates have declined since you first obtained your loan. You may find that now you can get a new loan at a lower rate of interest. You can reduce your monthly payments when you refinance from a higher rate loan to one with a lower rate. If you plan to remain in your home for several years, the savings you will realize in the form of a lower monthly mortgage payment could justify the costs of refinancing your home.

• To Build Equity Faster
  Many homeowners want to build the equity in their homes more quickly and choose to refinance from a longer term mortgage to one with a shorter term. That's because each month a certain part of your payment goes to the interest expense on your loan, with the remainder being applied against the principal, or loan balance. With shorter term loans, a greater percentage of your monthly payment goes to the principal. For example, if you currently have a 30-year fixed-rate loan, you might consider refinancing to a 10-, 15-, or 20-year loan, which will lower the total amount of interest you will pay over the life of the loan and speed up the growth of equity in your home.
  
  You can use the monthly payment calculator to compare how much your mortgage payment and your total amount of interest will be for loans at a variety of terms.

• To Switch from an Adjustable-Rate Loan to a Fixed-Rate Loan
  During those times when interest rates are higher, homeowners often choose adjustable-rate mortgages, which traditionally offer lower interest rates during the early years of the loan than fixed-rate loans. When rates come down, you may want to refinance to a fixed-rate loan, which provides the stability and predictability of knowing exactly what your mortgage payment will be for the life of the loan.

• To Switch from a Fixed-Rate Loan to an Adjustable-Rate Loan
  There are instances when a homeowner may wish to refinance from a fixed-rate to an adjustable-rate mortgage (ARM). For example, if you feel constrained by the expenses of your current mortgage, you could refinance to an ARM to gain the benefits of lower payments. Remember, however, that the interest rate on an ARM can increase at its periodic reset date, which means that your reduction in monthly payment amount may only be for a limited time. However, if you plan to live in your home for only a short time and then sell, refinancing from a fixed-rate to an adjustable-rate mortgage may make sense.

• To Draw on the Equity Already Built Up in Your Home
  Through what is often referred to as a "cash-out" refinance, you can tap the equity that has accumulated in your home to pay for expenses such as the education of your children and home improvements. For example, if your home is now valued at $150,000 and your loan balance is $80,000, you might be able to get a new $112,500 mortgage (cash-out refinances generally are limited to 75 percent of the total value of your home). That would allow you to repay the existing $80,000 balance and use the $32,500 for other financial needs.

  You can use the monthly payment calculator to compare how much your mortgage payment and your total amount of interest will be at different mortgage amounts. For example, you can compare the amount of your current mortgage versus your proposed cash-out refinance mortgage amount.

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2% rule of thumb?
The traditional refinance rule of thumb — that you must get an interest rate at least 2% below the interest rate you currently have — is often wrong. Why? Waiting for a two percent difference from your rate to show up in the marketplace can actually cost you money. For some people, as little as one-half of one percent can be enough, if all other factors fall into place. In addition, since ARMs are priced at below-market rates, it's almost always possible to get that 2% spread — though you may or may not want to. The only way to determine whether refinancing is for you is to go about it the right way: by analyzing the time and the cost factors.

What is your time frame?
Simply put, it's how long you plan on holding this mortgage, although it can be more complicated than that. You might have a product that demands refinancing — like a balloon mortgage — your time frame is only until the balloon period runs out. But, if you don't have to refinance, your time frame can be as long as you plan to stay in the home you're in. When determining your time factor, it's crucial to be honest with yourself, since the time factor will determine if and when you begin to save money. It's a fact that refinancing can cost a considerable amount of money, so you'll want to be as certain as possible of your time frame. For example, is it likely that your employer will relocate you to another city, or that you'll change jobs soon? Do you have a physical condition that could require you to move?

Evaluating all possibilities is vital, but only you know what your time frame will be.

More or less mortgage?
One other factor involved in refinancing your mortgage: how much money you'll need or want to borrow. Most lenders will let you borrow around 80% of your home's current appraised value. Some will allow more, if you're simply refinancing your existing loan. But, if you're looking to tap equity, known in the mortgage industry as a 'cash-out refi', you'll probably find that it's less than 80%. In many cases, cashing-out will mean that you'll have a larger mortgage balance than before, with possibly a higher monthly payment — and you'll have to qualify for that new mortgage.

Another consideration with a cash-out refi: you might not be able to get that nice low rate you've seen, if your mortgage amount will be above $300,700, known as a 'conforming loan'. Conforming loans are sold to large secondary market investors — mostly to Fannie Mae and Freddie Mac — and since they buy so many, the rates are often lower. However, loans above the conforming limit, known as 'jumbo' loans, often have interest rates as much as 1/2% higher than conforming, since they are bought and sold on a much smaller scale. This is also known as the 'jumbo premium'. In short, if you have to or want to take out a jumbo mortgage, be prepared to pay more for it.

Cash-out refi or home equity loan?
If freeing up cash in your home is what you'd like to do, there's a way to do so, even without refinancing: taking a home-equity loan. Home equity loans can be a viable alternative to a cash-out refi, although they are not without their own set of risks. Most Home Equity loans are of the adjustable-rate, revolving 'line of credit' type, and work much like a credit card does, and lenders will generally offer you as much as 75% of the equity in your home (the appraised value less the balance of your first mortgage). Most lines are pegged to the Prime rate plus a margin, but be careful — most don't have per-adjustment interest rate caps, and some have lifetime caps of as much as 25%. There are fixed rate home equity loans available too, and they function much like any first or second mortgage does, but will cost you more than a line of credit.

What are the closing costs?
Now that we know why you want to refinance, how long you're planning to hold the mortgage, and how much money you want or need to borrow, we can look into possibly the most difficult part: closing costs. Closing costs are what it will cost you, out of pocket, to obtain that new mortgage. Keep in mind, of course, that the more it costs you to get that new loan, the longer it will take to recoup those costs, so there may be some finite limits on what you want to pay.

While some closing costs are standard — that is, you'll find them all over the country — there are some that may be specific to your local market, or to your state. Estimating your costs will take a little research, but it's important because they'll cost you anywhere between $1000 to $5000 dollars. Along with the time factor, they will determine your savings (or costs) when you refinance.

The major closing cost in obtaining any mortgage are 'points', also known as 'discount' and 'origination' points. Origination points are treated differently for tax purposes, but each point is equal to 1% of the mortgage amount you borrow — $1000 each if you're borrowing $100,000. How many points you want to pay, or whether you want to pay any at all, depends upon how much cash you have available. Typically, paying more 'discount' points will lower the available interest rate, since they are a prepayment of interest; however, you may not know that points can often be traded off for a different interest rate — such as 9% and 3 points, 9.125% and 2 points, 9.25% and 1 point, and 9.375% and no points. (This is just an example).

So, if you decide that paying points is not for you, expect to pay an incrementally higher interest rate. Origination points are a different matter, since they technically are a fee, and they have no effect whatsoever on the interest rate you can obtain. (Some states limit the number of discount points a lender can charge in the making of a mortgage loan).
Of course, points (discount or otherwise) are only one of the costs involved with refinancing. As you well remember from getting your original mortgage, there are plenty of others waiting to tap your resources — costs for appraising your property, researching your title to the property, title insurance, credit checks, attorney review fees, inspections for insects, and others. These can easily add up to a few thousand dollars, but there may be ways you can reduce these costs. For example, if the lender who originated your mortgage still holds it, you might be able to simply update your title insurance policy, instead of taking out a new one. Or, if your original mortgage required Private Mortgage Insurance (PMI) because you put less than 20% down on the property, and your new mortgage will be 80% or less than the appraised value, you can probably drop your PMI coverage, saving you as much as the equivalent of 1/4 of one percent on your new interest rate. Shopping around and comparing can also help you save on these fees.

One other possible cost, depending upon where you live: TAXES. Some states have surcharges known as 'mortgage taxes', 'realty transfer taxes', 'mortgage recording fees' and others. It is very important to find out if your area is one that does charge these fees, since they can add as much as 2% of the mortgage amount to your closing costs, and significantly lengthen the cost recovery time.

What kind of mortgage should I get?
Getting the wrong kind of mortgage for your situation, even with a low interest rate, can, and often will, end up costing you money in the long run. Conversely, getting the right kind of mortgage, without a low enough interest rate, can make it take a very long time to recoup your closing costs.

That's because some mortgages are better suited for a shorter time frame, some for mid-length times, and others for the long haul. The time frame you have available will help determine what kinds of products are best suited to your needs. Refinancing to a 30 year fixed rate mortgage may be the wrong selection for you if you don't plan on holding the mortgage long enough to make it pay.

The biggest savings, as you'd expect, come from paying less interest. If you are comfortable with the monthly payment you are now making, it may very well be possible for you to refinance into a mortgage with a shorter term — 15 or 20 years, for example — for the very same monthly payment you have now. A 15 year mortgage payment is only about 25% higher than that of a 30 year — not double, as you might expect. While this won't put money back in your pocket every month, it will let you build equity in your home twice as fast, which can pay you back in a lump sum if and when you sell the home, or let you borrow larger sums against it later. Overall, where a 30 year, $100,000 mortgage (at 10%) will cost you about $216,000 in interest costs over the life of the loan, a 15 year term will only cost you about $94,000 — a $122,000 savings. So, the term of the loan you want can also help determine your overall savings.

As we mentioned, your time frame will determine the best types of mortgage for you. For example, if your time frame is reasonably short, say one to four years, you'll want to consider a short term mortgage, like a one-year adjustable rate mortgage. With a very low first year's interest rate, and a per-adjustment cap of 2%, you can virtually guarantee that low interest rate, in this example, would be at least 2% below an available 30 year fixed rate, and approximately 3% to 5% below your current interest rate. Don't laugh — a 4% interest rate spread would recoup $3000 in closing costs in less than one year, plus you'd still have a second year at below market rates. It's certainly worth considering an ARM if your time frame is very short.

As you'd expect, your mortgage choices expand as your time frame does. With a time frame of five to seven years, you might consider a balloon mortgage or the newer "Two-step" mortgage. With either, your payments are based on as long as thirty years, but your mortgage may end at a much shorter time. But, since your mortgage can end at a shorter time, you get an added benefit: an interest rate that is roughly 1/2% lower than the prevailing 30 year fixed rate mortgage.

If your time frame runs six years or longer, you can start to consider other mortgages, including the 30 year fixed rate; as an alternative, you could also consider taking an ARM, and be prepared to refinance again in another three or four years. This isn't as crazy as it may sound, as we'll show on the chart below by making a worst case assumption. (We assume the same points and closing costs on each mortgage).

Four Year cost analysis: 1 Year ARM versus 30 Year Fixed
$100,000 ORIGINAL MORTGAGE AMOUNT

1 Year Arm with 2% per adjustment cap and 6% life caps

30 Year Fixed rate mortgage at 9.50%

As you can see, even at a worst case, your 30 year fixed rate would still have cost you slightly more over the four year period. In addition, it's very possible that your ARM wouldn't have gone up the full 2% every year. In that event, if your rate didn't go up the full 2%, year, you would have saved money — perhaps even enough to pay for your next refinance.

How long will it take for your refinance to save you money? That all depends upon the difference between your existing monthly payment and the monthly payment on your new mortgage.

When will I break even if I refinance?
Most people want to recoup their closing costs within a "reasonable" amount of time — typically, three or four years. Of course, lowering your monthly payment (if that's why you refinanced) will put a few dollars back in your pocket every month. Your break-even point (the point where the savings each month has offset the cost of your refi) should be short enough that you enjoy at least a year or two of savings after the break-even point expired.

To start with, you'll need to know what the available interest rates are on the type of mortgage that fits your needs; the difference between your current and projected monthly payments; and your closing costs.