Refinancing your mortgage can save tons of money. But refinancing isn’t for everyone.

Are you wondering if mortgage refinancing – paying off an existing mortgage and replacing it with a new mortgage loan – is right for you? People typically refinance for a lower interest rate, often with a shorter loan term to save thousands of dollars on interest.

Refinancing typically involves a new credit check and another round of appraisal and closing costs. Your home must also meet a new mortgage lender’s loan-to-value (LTV) ratio, which is the amount you still owe on your original mortgage compared with the home’s appraised value. Just like with your original mortgage, you’re taking on a huge commitment.

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1. Save money with a more favorable interest rate

When interest rates drop, homeowners flock to lenders to shop for a mortgage that can save thousands of dollars over the life of the loan and could lower monthly payments. Savings on interest with a lower rate can be huge.

For example, on a 30-year mortgage at 6.0% interest and monthly payments of $1,199, the borrower would pay around $14,388 per year on the loan. However, on a 30-year loan with a 5.5% rate and monthly payments of $1,136, the homeowner would pay only $13,632 a year, a savings of $63 a month, more than $750 per year.

For example, compare the monthly payments (for principal and interest) on a 30-year fixed-rate loan of $200,000 at 5.5% and 6.0%.

2. Decrease the loan term to save thousands of dollars

Decrease the loan term to save thousands of dollars

Another way to save by refinancing your mortgage is to get a shorter loan term on the new mortgage. Generally, a 15-year mortgage comes with a slightly higher monthly payment but has a lower interest rate than a 30-year mortgage.

For example, with a 30-year loan at 6.0% with monthly payments of $1,199, you’ll pay more than $230,000 in interest. However, with a 15-year loan at 5.5% and monthly payments of $1,634, you’ll pay only around $94,000 in interest, a savings of $137,640 over the life of the loan.

For example, compare the total interest costs for a fixed-rate loan of $200,000 at 6% for 30 years with a fixed-rate loan at 5.5% for 15 years.

3. Increase the loan term for lower monthly payments

Increase the loan term for lower monthly payments

If your original mortgage is a 15-year loan, and you find that you’re having trouble making monthly payments, refinancing for a longer loan term will likely lower your monthly payments to a more affordable amount. However, while refinancing to increase your loan term can free up more money each month, it’s a short view of your financial situation.

By refinancing for a longer loan term, you may pay tens of thousands of dollars more than you’d have paid on the original mortgage. With that in mind, it might be better to look for a higher-paying or additional part-time job or trim other expenses in your monthly budget rather than refinance.

4. Get cash from equity on your home

If you’ve been paying on your mortgage for a while, especially if you put a sizeable down payment toward the purchase, you may have equity – the difference between what you owe on the mortgage and the actual value of your house – in the home. When you have equity in your home, you may be able to do a “cash-out” refinance with a new mortgage for a greater amount than what you currently owe.

Cash-out refinancing may not be the best way to pay off debt, though. The Federal Reserve Board recommends looking instead into a home equity line of credit, a revolving line of credit in which your home serves as collateral.

5. Avoid a prepayment penalty

Avoid a prepayment penalty

Some lenders charge a prepayment penalty when you pay your mortgage off early, including when you refinance. Before refinancing, find out from the original mortgage lender whether your mortgage has a prepayment penalty fee and how much it will be.

You may be able to get the prepayment penalty waived if you refinance with the same lender. However, if you must pay a prepayment penalty, weigh the cost of the penalty (along with closing costs and other refinancing fees) against any savings you expect to gain from refinancing.

6. Make sure the timing is right

Often refinancing can save thousands of dollars. However, if you’re planning to move in the next few years, you may not come out ahead with a new mortgage, even one with a lower interest rate.

That’s because the savings gained from refinancing may not outweigh the costs of the refinance itself. To find out whether refinancing could be worthwhile, use a mortgage refinance calculator to calculate if you will break even by recovering closing costs in one, two, or three years.

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About the Author

Deb Hipp

Deb Hipp

Deb Hipp is a full-time freelance writer based in Kansas City, Mo. Deb went from being unable to get approved for a credit card or loan 20 years ago to having excellent credit today and becoming a homeowner. Deb learned her lessons about money the hard way. Now she wants to share them to help you pay down debt, fix your credit and quit being broke all the time. Deb's personal finance and credit articles have been published at Credit Karma and The Huffington Post.

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