"Since it costs money out of my pocket to refinance, how do I know whether or not I will end up saving money?"

The Break-Even Period on a Mortgage Refinance

To save money, you must stay in your house longer than the "break-even period" – the period over which the interest savings just cover the refinance costs. The larger the spread between the new interest rate and the rate on your existing loan, the shorter the break-even period. The more it costs to obtain the new loan, the longer the break-even period.

But beware! The break-even period is not the cost of the new loan divided by the reduction in the monthly mortgage payment. This widely used rule of thumb is a misapplication of the principle that when explaining something to the consumer one should "keep it simple." Simple is good, except when it’s wrong!

The rule of thumb does not allow for the difference in how rapidly you pay off the new loan as opposed to the old one. Lets say that in 1992 you took out an 11% 30-year fixed rate loan, which now has a $100,000 balance and 21 years to run. You refinance into a 7% 15-year loan at a cost of $3,750.

Monthly payment on the old loan = $1019

Monthly payment on the new loan = $899

Reduction in monthly payment = $120

$3750 divided by $120 = 31 months

The rule of thumb says that you break-even in 31 months. However, because of the shorter term and lower rate on the new loan, in 31 months you would owe $7,041 less than you would have owed on the old loan. So, the rule of thumb in this case seriously overstates the break-even period. Taking account of differences in the loan balance, you would actually be ahead of the game in 12 months, as shown below:

Savings in monthly payment: $120 for 12 months = $1440

Plus lower loan balance in month 12: $2620

Equals total saving from refinance: $4060

Less refinance cost: $3750

Equals net gain: $310

Next consider the case where an 11% loan taken out in 1992 was for 15 years, and now has only 6 years to run, while you plan to refinance into a 30-year loan. With the remaining term shorter on the old loan and longer on the new one, the difference in monthly payment rises to $1238. Using the rule of thumb the $3750 cost would be recovered in only 3 months. But this fails to consider the slower loan repayment on the new loan. Taking account of the slower repayment, you don’t actually come out ahead until 14 months out.

The rule of thumb (dividing the upfront cost by the reduction in mortgage payment) approximates the true break-even period only if the term on your new loan is close to the unexpired term on your old loan. In other circumstances it can lead you seriously astray.

The rule of thumb also ignores the fact that if you had not refinanced you could have earned interest on the money you pay upfront to refinance; and if you do refinance and the payment is reduced, you can now earn interest on the savings.

Using a Refinance Calculator

My calculator 3a, Refinancing One FRM Into Another FRM, allows you to take account of all the factors that affect the profitability of refinancing a mortgage. These include the time value of money, taxes, and differences in the cost of mortgage insurance between the old and new mortgage. This calculator assumes that you have only one mortgage and you don't take any cash out of the transaction. Other refinance calculators are available for borrowers who have a second mortgage or want cash from the transaction.

You've saved up a nest egg, tweaked your credit score to make sure that it's the best that it can possibly be, and secured gainful, steady employment. Now you're ready to get a home loan and purchase your dream house. How does the process work?

One of the first things you'll need to do is to locate a lender. You can use the Internet to compare lender offers, find loan officer references through friends, or triangulate to find a lending institution conducive to your financial goals by getting references from disinterested real estate agents.

The next step is to fill out your mortgage application (called a 1003). Make sure you understand the closing costs, prepayment penalties (if any apply), and terms of the agreement. Your lender must provide an estimate to you within three business days of getting your application.

Work with several lenders to compare fees, and don't hesitate to negotiate. If you can pay more points on your loan, you'll be able to reduce your interest rate. However, you don't want to necessarily drain your nest egg to qualify for a better rate. Your mortgage should be couched as a major part of your long-term financial plan.

Some lenders will require you to pay fees upfront. This money goes to assessing your credit report, processing paperwork, and potentially doing an appraisal of your dream property. Next, hand over paperwork and documentation to your mortgage processor. Examine your papers under the microscope before you close your loan.

Sometimes lenders will try to change conditions and terms at the last minute and pressure you into signing a less-than-stellar agreement. Don't allow your lender to push you around.

Once you've finished your agreement, you'll have to deposit your down payment into an account and then move that money into your escrow company or title entity. Be aware that you generally don't want to work too many lenders, since every lender inquiry can lower your credit incrementally.

Lower your so-called debt-to-income ratio, and you'll be in a much better position to get the rates you want. Finally, peruse the national housing rate regularly, and research how much properties cost in your target area, so you can intelligently negotiate a good mortgage rate.

To qualify for a mortgage, you generally need to present lots of paper work to your lender. Some of the basic documents include your credit history and proof of income. Lenders need to examine your credit history to gauge whether you're worthy of risk. Although your FICO score is important to your lender's calculation, it's not the only piece of evidence underwriters consider when evaluating credit risk.

Lenders will take a look at any red flags or complaints in your credit report, creditor explanations, and so forth. Be aware that you'll have to hand over critical personal information, such as your social security number and your birthday, so take care to ensure the confidentiality of this info to avoid identity theft.

Lenders will also want to check out your recent income history to make sure that you're going to have enough funds to make good on your loan. You might have to compile W-2 forms, as well as verification that you are employed. The proof of income documents required can vary from lender to lender, and you may have to provide information for both you and your spouse if you're buying the house together.

In addition, if you have information about assets, such as 401k plans, mutual fund investments, and stocks, you can provide this data to the lender to support your claim that you are a worthy risk. Lenders want to know that you have lots of assets on hand to manage financial crisis.

A beefed up asset portfolio can help you qualify for lower rates -- even if you don't have an incredibly stable income history. (For instance, if you're a freelance writer and editor, you can get on the lender's good side by demonstrating a healthy asset portfolio.)

You have to include paperwork relevant to the purchase. Lenders will want to see homeowner's insurance paperwork as well as title insurance documents. You'll also have to supply what's known as an earnest money deposit document. Basically, this piece of paper demonstrates that you have deposited enough cash down to afford the house.

You may not be required to show this earnest money deposit, but you should be prepared. Have all your documents prepped and ready to go, so that the lender can process your application quickly. Delayed processing can potentially cost you on your interest rate, which can in turn translate into thousands of extra dollars you might have to pay in the future.