When you refinance your mortgage, you take out a new loan at a lower rate or for a different term and use the proceeds to pay off the original mortgage. Most lenders require you to have at least 10 to 20 percent equity in your home before you can refinance.

When Does It Pay to Refinance?

How do you know if the difference in interest rates is enough to make refinancing worthwhile when you include the costs of closing on the new loan? The old rule of thumb was that interest rates should be at least 2 percentage points below your current rate, but the low-cost refinancing that many lenders now offer makes that guideline obsolete. Refinancing may make sense if you have a second mortgage or home equity loan with a higher rate. You can save money by rolling both your first and second mortgages into one new loan with an overall lower rate. Refinancing also makes sense if you want to take advantage of lower interest rates to shorten the term of your loan, from thirty years to fifteen years, for example, for around the same monthly payment. You'll pay off your mortgage many years sooner and slash total interest costs dramatically.

Sometimes refinancing doesn't make sense. If you've had your mortgage for more than ten years, for example, you could end up paying a lot more in interest by refinancing at a lower interest rate. That's because in the early years of a mortgage most of your payment goes toward interest and very little is applied to your principal balance. By the time you've been making payments for ten or more years, you've started to make some dents in the principal, and if you refinance with a new thirty-year loan, most of your payments will once again be interest. Evaluate your situation carefully and consider not just the monthly payment, but also the total interest costs over the life of the loan added to the total interest costs you've already paid. Online calculators can help you quickly determine the total interest under different scenarios.

The Time Frame Issue

The first question to ask yourself when you're thinking about refinancing is how long you expect to live in the house. If you plan to move within the next three years or so, you may not have enough time to recoup your closing costs. Assuming you'll be sticking around, the next thing you need to do is get a detailed written estimate of your closing costs from the lender.

To figure out how long it will take you to pay off the cost of refinancing and really start saving money, deduct the new, lower monthly payment from your current payment to find your monthly savings. Multiply your monthly savings by your combined effective state and federal tax rate to get your tax cost and subtract this from your monthly savings. The reason for this adjustment to your savings is that your new loan with the lower payment reduces the tax benefit you had under the old loan. Now divide the total of all the fees and closing costs on the new mortgage by your net monthly savings after the tax adjustment. This is how many months it will take you to pay off the cost of refinancing.

For example, let's say that your closing costs are going to be $3,000. Your current monthly payment is $875 and your new payment is $750, a monthly savings of $125. If your combined effective state and federal tax rate is 20 percent, decreasing your interest payments by $125 per month will increase your taxes $25 per month ($125 × 0.20), so your net savings are $100 ($125 – $25). Your closing costs of $3,000 divided by your monthly savings of $100 equals thirty months, the time it would take to repay your closing costs and start saving money. If you plan to be in your home for more than thirty months, it makes sense to refinance. Before you do, check with your lender and make sure there's not a prepayment penalty on your current mortgage. If there is, it may cost you more to refinance than it's worth.

Look at the Big Picture

When it comes to mortgages and home equity loans, the bottom line is to look at the big picture whenever possible. If you're on a tight budget and can barely qualify for a thirty-year mortgage, you may not have any other options, but if possible, look beyond the monthly payments to your overall financial plan. What will benefit you the most in the long term? Even if you'd love to have a fifteen-year loan to build equity quickly but can't quite swing it, you may be able to make extra principal payments on your thirty-year loan. You'd still come out ahead without the monthly commitment to higher payments. Whatever road you take, be sure to leave enough financial cushion so that you're able to contribute to your 401(k) and save for your other financial goals.

Cash-Out Refinancing

Some people refinance for more than the value of their current mortgage if they have a lot of equity in their home. This is called cash-out refinancing. Let's say you paid $125,000 for your house and your mortgage is $100,000. Your house has appreciated in value and is now worth $175,000. You might refinance for $140,000, pay off the balance on your $100,000 mortgage and pocket the difference of $40,000 or more. You'd still have 20 percent equity in your home ($140,000 % $175,000 = 80 percent). Don't forget that your monthly payments would be significantly higher, so make sure you can afford them. If you're planning to borrow anyway to make improvements to your home, this may be the way to go instead of taking out a second loan to pay for the renovations.