PHOTO: iStock

If you’re a homeowner, the idea of refinancing your mortgage has undoubtedly crossed your mind over the last few months. With interest rates at an all-time low, many Americans are considering a refinance right now, hoping to lock in lower mortgage payments for potentially the next decade or more.

But just because others are refinancing their mortgages doesn’t mean that you should. There are many factors to consider in a refinance, and the process can be confusing if you don’t understand the terms or how it works. With that in mind, we’ve created this guide to educate homeowners on how to refinance your mortgage, so that you can make an educated decision as to whether a refinance makes sense for you.

What is refinancing?

Refinancing is the process of paying off your existing mortgage with the funds from a new mortgage. While most people refinance to take advantage of a lower interest rate on a new loan, other reasons to refinance include switching mortgage companies, changing the terms of your loan or ending a private mortgage insurance requirement (also known as PMI, more on this below).

Refinancing is also a good way to acquire cash to use for home improvements, buy another house or pay off credit card debt.

The process of refinancing is very similar to applying for a mortgage. Before you begin, you’ll need to contact a bank, credit union or mortgage broker and discuss your options, which include a new loan’s terms and costs. Some online services like LendingTree can help automate this process for you by reaching out to multiple lenders at the same time so you can see your options all at once.

Once you’ve chosen a lender, you’ll also need to gather a number of documents, such as pay stubs and tax returns, to demonstrate your income and overall financial picture. The process is fairly simple, and while the cost savings vary from person to person, if you do find that you’re able to save a few dollars a month, it could be well worth it.

Click here to compare offers from refinance lenders at LendingTree, an online loan marketplace.

What do all these refinance terms mean?

When it comes to refinancing, there are a number of words and terms that you should become familiar with. Many of them are key variables that you’ll want to take into consideration to determine whether refinancing makes sense for you.

Here’s a glossary of the most important refinancing terms:

Interest rate: This is the amount of money that your bank or credit union charges each year for lending you money in a mortgage. It’s expressed as a percentage (i.e: 3%, 4.25%, 5.76%). The lower your interest rate, the less you’re paying in interest.

Annual percentage rate (APR): This is the actual cost of a loan to a borrower. It differs slightly from the interest rate as it includes not just interest, but also additional costs charged by the lender. Again, it’s expressed as a percentage, and lower is better.

Points: These are optional fees paid to the lender to lower your interest rate, which will make your monthly payment smaller. Each point typically costs 1% of your total mortgage amount and reduces your interest rate by 0.25%. So if you’re refinancing a $200,000 mortgage at a new interest rate of 4.25%, you could pay $2,000 for 2 points and reduce your rate to 3.75% on the new mortgage.

Closing: The very last step in a refinance. This is when you will sign all the final legal documents accepting responsibility for the new mortgage, and the funds from your new lender will be transferred to your old lender so your existing mortgage can be paid off.

Closing costs: The fees you’re charged to finalize a mortgage — whether it’s for a new home or a refinance — which you must pay at closing. Sometimes a lender might offer a “no closing costs” refinance option, but you’ll likely pay a higher interest rate for it.

Equity: The difference between your home’s current market value and the amount you owe the lender. This is how much of your home you actually own. For instance, if your home is currently worth $300,000 but you have $175,000 left to pay on your mortgage, your equity in your home is $125,000.

Cash out refinance: Refinancing for an amount higher than what you owe on your current mortgage and keeping the extra money. This reduces your equity, but allows you to get cash that can be spent on other necessities, such as home improvements, credit card debt and so on.