The No. 1 Thing to Do Before You Refinance

Everyone wants to save money and get a great deal on his or her home, but refinancing is about more than that — it’s about getting the right loan for your situation.

But what is your situation? It may have changed since you first bought your home. Have interest rates fallen? Has your credit score improved, making you eligible for a lower-rate mortgage? Or would you like to switch to a different type of mortgage?

The average interest rate on an outstanding mortgage in early 2012 was 5.098%, according to the Bureau of Economic Analysis. But today, lenders are offering rates that are lower and if your credit score has improved, that’s even more of an incentive to refinance.

When you refinance, you pay off your existing mortgage and create a new loan, a process that comes with a few costs. How far along you are in paying off your mortgage and how long you plan to remain in the home determines the most suitable product for you — that is, if refinancing is even a good option in the first place.

For instance, if you plan to be in your home fewer than five years, the lower rate you’ll get may not be worth the refinancing fees you’ll have to pay. But if you’ve lived in your home for several years, you can get a better rate on a 10- or 15-year loan, which can result in savings or years cut off of your repayment.

Identify your personal financial goal
Before deciding to refinance, consider how much you’ll pay per month, how much you’ll pay in interest versus principal, and how long you’ll be making payments. Most importantly, consider your primary personal financial goal:

• Saving money: A low-interest loan can help you save in both the short and the long term.
• Increasing your cash flow: You can build savings, pay off bills that need immediate attention, or reduce another large loan, like tuition or a car payment.
• Wanting a predictable payment: Financial planning can be hard with an adjustable-rate mortgage, or ARM, but switching to a fixed-rate loan can help. With an ARM, monthly payments will change as the interest rate changes.
• Shortening the term of your loan: You can achieve lower interest rates and get rid of your mortgage that much quicker, but you will be paying higher monthly payments.

To achieve your primary financial goal, first find out if getting a refinance is possible and worthwhile. Here are a few things to consider:

• Can you afford the refinance once you assess the short- and long-term costs? Consider how long you’ve had your loan — if your current payment is applied to your loan principal, understand that refinancing would restart the amortization process and most of your monthly payment would go toward interest, not to building equity.
• How long will you live in your home? If you’re planning on moving in the near future, you may not be there long enough to realize the benefits of a refinance.
• Does your current mortgage have a prepayment penalty? A prepayment penalty is a fee lenders charge if you pay off your loan early, including for refinancing.
• Are you eligible, and if not, what can you do to become eligible? Look at your credit history and current financial situation. Perhaps you can pay down debt to get a better interest rate.

Knowing when to refinance and what sort of loan is the best fit for your personal situation and financial goals can be tricky. That’s why it’s a good idea to work with a reliable mortgage professional that has your best interests in mind.