Should I refinance? Or should I mean ...

You hear that mortgage rates are at historic lows, hovering near record levels of inflation. It's practically free money in the long run.

However, they committed to a fixed rate mortgage a few years ago, so pay 6 percent, while neighboring child pays 3.25 percent. If you refinance?

What is refinancing?

First, a background for the reader vocabulary, "refinancing" a mortgage to get a new mortgage. They "repeat-Finance" - a modified payment plan to pay back.

Pro for refinancing

Many people who have a mortgage to refinance fixed rate is motivated by the opportunity to engage a lower interest rate.

Small differences in the interest rate makes a big difference. Compare two 30-year mortgage of $ 240,000. An interest rate of 4.00 percent is raised, and the other is at an interest rate of 4.25 percent.

That does not sound like a big difference to sound, right? There is only one quarter of one percent, right? What difference would it make?

Compound small amounts in large numbers. At the end of 30 years, the owner of 4.25 percent on an additional $ 10,000 over the term of the loan in relation to the door of a mortgage from 4.00 percent to be paid.

Obviously the biggest advantage of refinancing is the way to reduce your interest rate, shaving thousands of full payment of the loan.

Refinancing

But every coin has two sides: the refinancing will launch the new clock on your mortgage, make your repayment back to the square table.

"Huh What does this mean?"

Here's how mortgages work: When you make a payment, a percentage of the payment goes to interest. The balance goes to your original principal.

The more that your payment for your capital is better used. Pay your principal amount, you can pay off the loan faster. (This is why we must ensure that all additional mortgage payments applied to principal).

When you start a new mortgage, most of your payment applied to interest. Only a small fraction of that goes to his head. At the end of the first year of their mortgage payments, you will see that there is hardly a dent on your principal balance.

The more you advance on your mortgage, your payments more for your capital. For its 25th year, the 30-year mortgage, almost all of your payments will be applied to your principal.

"It's fascinating, really. (Yawn). But how does this apply to refinance?"

When you refinance a mortgage, it is set back to a single year the clock. Most payments are interest, not the principal applied.

If you have your mortgage in the early years still, it's not a big deal. But if you are more on your mortgage, you need to run a spreadsheet to see if the lower interest rate justifies rewind clock.

(Read more: Should I buy or rent?)

Example no. 1

Let's say Joe has a $ 100,000 mortgage with an interest rate of 6 percent. Your monthly payment is $ 599.

At the end of Year 1, Joe paid $ 7,188 on your mortgage. Only $ 1299, the outstanding principal balance is paid. The residue was purified by Interest swallowed.

Only a year after his 30-year mortgage, Joe discovers that he can get a new loan at 5 percent. Joe refinance your old mortgage closing and start the clock. Pay $ 1000 closing costs for the new loan.

At 6 percent, Joe would have paid $ 109.871 in interest payments over the term of the loan (pay a total of $ 209.871 to $ 100,000 home).

By refinancing, Joe "loses" the interest that you paid for the first year of the loan $ 5889th Ouch.

But it's worth it. By opting for a mortgage of around 5 percent, now Joe will pay $ 95.483 in interest over the term of the loan, instead of $ 109,871. In other words, it allows their movement to save $ 14,387.

Example # 2

But suppose Joe was in the year 15 of his 30-year mortgage, when he discovered the ability to refinance.

He does not want a new 30-year commitment, so that refinancing a mortgage for 15 years. What happened?

Despite the task of low interest rates to 5 percent and accelerated payments on a mortgage to 15 years, Joe actually pays more interest in refinancing, as it did in the original scenario. In other words, it is a terrible thing refinancing for Joe, because it is too far into your mortgage.

The Bottom Line

Do not assume that refinancing is always a good or bad idea. Close the interest rates, loan terms and closing costs on a spreadsheet or refinancing calculator online to determine if the potential deal that would provide a sense for your particular situation.

In general, if you met in the early years of mortgage payments and you can interest rate of 0.75 percent or more, you should consider. The earlier in your mortgage refinance better.