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Refinancing your mortgage could potentially lower your mortgage payments, save you thousands over the life of your mortgage, and convert some of your home equity into cash. However, before you sign on the dotted line, it's important to know exactly what you're getting into, and whether or not refinancing is the best move for you.

What is refinancing?
Refinancing basically refers to obtaining a new mortgage to replace your current one. Homeowners choose to refinance for a variety of reasons, but all of these can fit into one of two categories -- rate-and-term refinancing, or cash-out refinancing.

Rate-and-term refinancing refers to the act of refinancing your mortgage with the main goal of changing your loan's terms. Maybe interest rates have dropped since you originally bought your home, and now you want to take advantage. Or, maybe you have 24 years left on a 30-year mortgage and you'd like to switch to a 15-year mortgage to lower your interest rate and pay off the home faster.

Cash-out refinancing refers to obtaining a new mortgage for more than you currently owe, and receiving some cash at closing. People do this for several reasons, as I discuss below -- some bad and some good.

Refinancing your mortgage to lower your payment
First, let's take a look at refinancing your mortgage with the main goal of lowering your monthly payment. This can be a good idea if interest rates are considerably lower than when you obtained your current mortgage, or if your credit score has improved significantly and you can qualify for a mortgage with better terms now.

The main question to ask yourself when attempting to lower your payment is whether it will be worth it in the long run. You can answer this by calculating your breakeven point. Just like your original mortgage, when you refinance a mortgage, you'll need to pay closing costs. Determining the breakeven point tells you how long you'll need to pay the new mortgage before the savings add up to more than the closing costs you paid to obtain the loan.

As an example, let's say you obtained a $250,000 30-year mortgage five years ago, and that your interest rate was 5.5%. According to an amortization calculator from Bankrate.com, your monthly payments on this loan would be $1,342, and you would still owe $229,572 with 25 years remaining. If you can refinance this balance at a 4% interest rate, it would drop your payments to $1,096 -- a savings of $246 per month.

Closing costs on a mortgage refinance are typically 1% to 2% of the loan amount, so let's say this loan has closing costs of $3,500. To calculate the breakeven point, you need to divide the closing costs by the amount you save per month.

So, by dividing $3,500 in closing costs by $246 in monthly savings, we see that in this case, it would take just over 14 months to break even, making this refinance a no-brainer as long as you plan to live in the house for over a year. However, if you do the math and calculate a longer breakeven period, it only makes sense to refinance your mortgage if you're certain you'll be in the house long enough for the savings to exceed the costs.

Also, bear in mind that if you refinance an existing mortgage into a new 30-year loan, you're committing to make payments for a longer period of time (five more, in our example).

Refinancing your mortgage to change your terms
Another practical reason to refinance is to change the terms of your mortgage. For example, if you obtained a mortgage with an adjustable rate, it may be a good idea to refinance into a fixed-rate mortgage to keep your payments constant.

Or, if you want to pay off your house faster, you can refinance into a mortgage with a shorter term. Let's say you have 23 years left on a 30-year mortgage at 6% interest, and that the original balance was $300,000 -- which translates into a remaining balance of approximately $269,000 and monthly payments of $1,799.

If you choose to refinance this into a 15-year mortgage in order to pay off your home eight years sooner, you could obtain an interest rate of about 3.2% as of this writing, which would increase your monthly payments to $1,884. However, with a manageable $85 more per month, you can save yourself more than $131,000 in interest and be free of housing debt in roughly two-thirds of the time.

So, if you're in a situation where changing your terms could produce significant savings or stability, it may be worth refinancing your mortgage.

Refinancing your mortgage to tap into your home equity
Finally, it's also common for people to refinance their mortgages in order to take some cash out of their homes. For example, if you owe $200,000 on your home and obtain a refinance mortgage for $230,000, you can walk away from the closing table with a check for $30,000 to do whatever you want with.

The main question, here, is whether or not you want to take some cash out of your home for a smart reason. Just to name a few examples:

  • It may be a good idea to take cash out in a refinancing in order to pay off high-interest debt like credit cards. You're unlikely to be able to borrow money for debt consolidation at the low interest rates you could obtain in a mortgage refinancing, so it could be a smart way to save yourself lots of money in credit card interest.
  • You may want to finance home improvements that will add significant value to your home. Bear in mind this doesn't refer to luxury items or things that don't add much equity, like a swimming pool. However, there are some renovation projects that won't fully pay for themselves, but tend to recoup most of their value in the form of increased equity. After all, it makes more sense to borrow $30,000 at a low interest rate if the value of your home increases by $25,000 -- plus, in the meantime, you'll have an improved home to live in.
  • Other good reasons to take cash out could include (but are not limited to) paying for college expenses, paying for emergency expenses, or purchasing an investment property. Of course, these all depend on your personal situation and whether or not there are more attractive ways to finance them.

On the other hand, it's generally a bad idea to treat your house as a piggy bank and take cash out for things like vacations or large unnecessary purchases.

Shop around before you choose
The best advice I can offer would-be mortgage refinancers, other than the considerations already discussed, is to shop around for your loan. Far too many borrowers apply for a mortgage with just one lender and accept whatever interest rate and fees that lender offers.

Instead, even though mortgage applications can be lengthy, it pays to fill out pre-approval applications with several lenders in order to compare the costs. Although banks tend to offer similar interest rates, a small difference can save you thousands of dollars over the long run.

For example, let's say that you want to refinance a $250,000 mortgage, and you have obtained two quotes. Both loans have closing costs and fees of $4,000, but the interest rates are slightly different -- 4% and 4.1%. At first glance, this may not sound like much of a difference at all, but you may be surprised to learn that the lower-rate option can save you more than $5,200 over the life of a 30-year mortgage.

It won't adversely affect your credit to do some shopping. There are special provisions built into the FICO credit scoring formula that allows multiple mortgage inquiries to be treated as just one, as long as they all occur within a short time period. In other words, by filling out several applications to refinance your mortgage and searching for the best deal, you have nothing to lose and everything to gain.

The Foolish bottom line
Refinancing your mortgage can be tempting, but whether or not it's a good idea depends on your individual circumstances and how much it's going to cost to obtain a new mortgage. If you consider the pros and cons, and discover that the benefits of refinancing outweigh the costs and additional time you'll spend paying the mortgage, shop around and find the best possible deal before you commit.

Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.