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When to refinance your mortgage

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A prepayment penalty on your mortgage is another reason to consider delaying a refinancing. The penalty payment creates another layer of expense. While Bankrate's refinancing calculator will let you incorporate the cost into the decision to refinance, if you can wait out the typical two to three years that the prepayment penalty is in place, you're likely to improve your results when refinancing. Of course, interest rates could be much higher at the end of the prepayment penalty period than they are today.

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If you're struggling to make your mortgage payment, but can't get a refinance, you may want to try to negotiate a mortgage modification. The Bankrate feature "Borrowers look for mortgage modification" offers more information.

Type of refinancing
If you decide that a refinance is the right move, you'll have to decide what type of new mortgage is right for you. The two major types of refinances are cash-out refinancing and standard "plain vanilla" refinancing, where you are just refinancing the existing mortgage balance.

In a cash-out refinancing, you take out a new mortgage on the same property in which the amount borrowed is greater than the amount of the previous mortgage. The difference is taken out in cash.

Freddie Mac classifies a cash-out refinancing as a new mortgage with a new loan balance at least 5 percent larger than the old loan balance.

A cash-out refinancing will typically have a slightly higher interest rate than a plain-vanilla refinancing because the lender has more money at risk. Cash-out refinances often are used to pay down debt, but this type of mortgage has both pros and cons.

For example, imagine that you use a cash-out refinance to pay off credit card debt. On the pro side, you're reducing the interest rate on the credit card debt and freeing up lines of credit on your credit cards.

On the con side, you may pay thousands more in interest expense because you're taking 30 years to pay off the balance you transferred from your credit card to your mortgage. You also run the risk of running the balances back up on your credit cards and not being able to make the payments.

However, the biggest risk in this scenario is in converting an unsecured debt into a secured debt. If you can't afford your credit card payments, you get nasty calls from debt collectors, a black mark on your credit report and a lower credit score.

Miss a few mortgage payments and you can lose your home to foreclosure.

Tip: Tidy up credit
Getting your credit history and credit score in the best possible shape will help you get a better mortgage rate. Review your credit reports and get copies of your credit scores as well. You're entitled to at least one free credit report each year from each of the three credit bureaus, but you'll have to pay to get a copy of your credit scores. Bankrate provides help in disputing errors in your credit report through the feature "7 steps to fixing your credit report."

On the other hand, plain-vanilla refinancing is intended to replace your existing mortgage with a new one at a lower rate. There's no cash out, unless it's to cover closing costs.

 
 
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