What do I need to consider before refinancing?

Given current market conditions, refinancing could be a great way to take advantage of record low rates. Unfortunately for borrowers, the tight credit conditions have given rise to a higher loan-to-value requirement. This means most lenders are requiring that you have at least 30% equity in the home. Before you head to your lender to start the refinance process, there are a number of things to think about.

Shop for the best rate

Your lender may be able to waive a few fees and the process might go quicker, but just a 1.00% drop in interest rate can make a dramatic difference in your payments as well as in the interest paid over the life of the loan. On a $200,000 30-year loan, a rate of 5.00% compared to 6.00%, you can save more than $45,167 in interest over the loan term.

But refinancing can also be more costly than you might have guessed. You need to consider all the cost factors before you make the decision to refinance, including origination fees, points, documentation and processing fees—all of which can add up to thousands of dollars.

Shop for the lowest closing costs

One area that can save you money is closing costs. While rates may be fairly similar from lender to lender, closing costs can vary dramatically. You can save money by shopping around for the lowest closing costs. It's a good idea to ask each lender for a Good Faith Estimate. This document will outline the potential fees if the loan closes with that lender. Compare them side by side to identify the potential savings. Ask about and look at the APY vs. the APR. The closer these two rates are, the lower the closing costs are.

Keep in mind that shopping for a lower closing cost may mean that you don't get the rock bottom rate at the time. Compare the out-of-pocket closing cost to how much lower the rate are you getting. For instance, you might have to pay one percent point in fees in order to get the loan to get a lower rate.

Refinance for the same or lower term (30 years vs. 15 years)

Interest rates have a tremendous impact on your payment amount. A two-percentage-point drop in rates can mean quite a bit of extra money in your pocket each month if you refinance. But before you jump into another thirty-year loan, consider shorter-term home loan refinancing. Your payment may remain relatively unchanged, but you could pay off your home sooner and save thousands of dollars in interest in the long run.

Let's assume you have a $150,000 mortgage financed at 8% for thirty years and that your monthly payment is $1,100.65 (excluding taxes and insurance). If you refinance the same loan amount at 6%, your payment will drop to $899.33 per month. But if you decide to refinance for fifteen years at a rate of 5.8%, your monthly payment increases to $1,249.63. But you will shave 15 years off of the repayment, which means a savings of more than $98,000 in interest. In some real estate markets, these savings would buy a second house!

Alternatively, you could refinance for 30 years, but treat the loan like a 15-year loan by making the 15-year payments that are usually listed on the statement. It will take some discipline, and you will have a slightly higher rate than the 15-year mortgage. What it will give you, though, is flexibility. Make the 15-year payment every month, but if in any given month you need the extra cash for an emergency, make the normal 30-year payment. Then jump back on the 15-year payment amount the following month.

By avoiding these mistakes, and by being diligent throughout the transaction, you could save thousands of dollars.

Refinancing to drop Private Mortgage Insurance (PMI)

If you are one of the many homeowners who did not make a down payment of 20%, you might have PMI or Mortgage Insurance Premium (MIP) on your loan. Refinancing is one way to eliminate PMI if your loan amount is 80% or less of your home's value. If your home is valued at, say, $100,000, then your loan amount must be less than $80,000. Many people rush out to refinance the minute they think they may have 20% equity.

But be careful. Home loan refinancing can be an expensive experience, at least in the beginning. If the appraisal of your home does not reflect a Loan-To-Value (LTV) of 80%, you are no better off than you were—and you've likely paid a few hundred dollars for a worthless appraisal. Before you order an appraisal, talk to an appraiser. Though they cannot guarantee an appraised value, they can usually give you a ballpark figure that can help you decide whether it is worth the risk to pursue it.

If you determine that it does not make sense for you to refinance at this point, consider taking out a home equity line of credit (if available in your state). You can use this home equity line of credit to payoff and manage higher cost consumer and credit card debt. This will allow you to take advantage of a tax deduction on your home equity line if it's less than $100,000. For example, if you have credit card debt that's costing you say 12%, you can instead use your equity line to pay off that debt likely at a lower rate, say 6%. Not only that, the interest paid on the home equity line is deductible up to $100,000.