Mistake #1: Not Refinancing Sooner

The point at which refinancing makes sense depends on three factors: The drop in rates. The closing costs. The length of time before you'll pay off the loan.

If you'll be in the house for many years, it may pay to refinance, even if the rate has dropped far less than 2%. Let's say you have a $100,000 home loan that you took out 5 years ago when the rate was 8%. You've been paying $734 a month. Rates have now dropped 1%, to 7%, and you plan to move in 5 years. Does it pay to refinance?

Your current balance after 5 years and more than $44,000 in payments is about $95,000. That means you've paid $9 for each $1 of equity you've gained. Ouch.

Let's assume closing costs are $2,500 and you can refinance at 7%. Borrowing $95,000 (you pay the closing costs out of savings), you'll cut your monthly payment by $102 (to $632). To recover your $2,500 in closing costs would take 25 months. Conclusion? If you'll be in the house for more than 25 months, refinancing with a 1% rate drop will make sense.

How about half a percent? Your monthly payment would drop to $664, a savings of $70. It would take about 3 years to recover the closing costs. The truth is, the only way to know if refinancing will pay is to do some math.

Mistake #2: Not Putting Your Savings to Good Use.

Return with us now to your original 8% loan, with a balance due of about $95,000. If you hold onto this loan and just pay the required $734 a month, you'll pay off your loan in another 25 years, at an additional interest cost of $124,613.

Refinance at 7% for 30 years, and you'll pay $132,531 ... almost $8,000 more! Why? You've stretched your term out by 5 years. Remember how the first 5 years cost $9 for every dollar you paid off? It's the term of the loan that increases the cost the most. Those first years are very expensive.

But what about that $102 you'll be saving each month? If you use it to pre-pay your new loan, you'll cut your interest cost to $82,557. That's a savings of $42,056! The reason? Instead of extending your loan's term by almost 5 years, you'll have reduced it by 5 years.

To save even more, use that $102 a month to pay down more expensive credit card bills.

Rule of Marc's thumb: Calculate your potential savings whenever rates drop ... and be sure to plow your refinancing savings into your debts. (I used my Banker's Secret Software to crunch the numbers.) The program is available for both PC's and MAC's.