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Refinancing Can Mean Big Savings

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Whenever interest rates drop, as they sometimes do when Alan Greenspan gets a little out of hand, homeowners might have the opportunity to save money. Lower interest rates generally translate into lower mortgage loan rates, and refinancing your mortgage at a lower rate can save you a few bucks on every monthly payment.

Deciding whether to refinance your home comes down to a basic calculation: Will your savings from reduced mortgage payments be greater than the up-front costs? Therein lie the guts of the refinancing decision.

Lose the thumb, use a calculator

When it comes to making this kind of financial calculation, everybody wants a simple "rule of thumb," and the financial trade is usually quick to oblige. Most commonly we are told to look for a minimum interest rate improvement of, say, two percentage points from our existing mortgage before we get serious about refinancing.

When it comes to mortgage refinancing, however, such rules of thumb can be misleading. The interest rate cut required to come out ahead will vary dramatically depending on how long you plan to hold the new mortgage, how many years you've already paid on the current mortgage, and the increasingly available opportunities for cutting closing costs.

It's hard to come up with one rule that covers all the possible scenarios with reasonable accuracy. However, you can take the specific numbers that match your unique situation -- how much remains on your loan, what rate you're currently paying -- and input them into an online calculator.

For example, the Fool provides a simple "What will my refinancing costs be?" calculator that serves nicely as a checklist of common closing costs. Use it as a guide for surveying potential lenders. Once you get the data from lenders and plug it into the calculator, you will be given expected closing costs -- the size of the interest-savings hurdle you must jump to come out ahead.

Your refinancing savings

The second half of this calculation is how much you'll save in mortgage interest payments after refinancing. This is generally a clear-cut calculation, with one catch: To cover closing costs, you have to shell out today's money, but the interest savings you capture in return will arrive in the future, over time. Since the time value of money dictates that tomorrow's one dollar isn't as valuable as today's, it makes sense to convert your future interest savings to today's dollars for a fair comparison to closing costs, particularly if you'll be holding the new mortgage for many years.

If that last paragraph tied you up in mental knots, never fear. Our second refinancing calculator, "Am I better off refinancing?," takes care of the math behind the scenes and spits out an answer for you. If you worked through the closing costs calculator first, you'll find that a lot of the required information for this second calculator will already be in hand. You'll just have to add information about your existing mortgage, the loan you're trying to beat.

Are there any other reasons to refinance?

You may have an adjustable-rate mortgage (ARM) and find that you're uncomfortable not knowing exactly what the payments will be -- so you'd like to switch to a fixed-rate mortgage.

Alternatively, you might want to stick with an ARM, but you may have found one with a lower interest rate, or with appealing features such as payment caps that are lacking in your current loan.

If you choose not to refinance, you might still ask your current lender whether it is possible to modify your current loan in order to have it better serve your needs.

One caution

Should your current mortgage include a prepayment penalty, this could be a problem. If it is large enough, this penalty could offset the savings you gain by refinancing in the first place. Your current mortgage documents will indicate whether there is a penalty for prepayment. If there's any question, ask the lender for clarification.