A lower monthly payment is great, but only if you can truly afford it. But how do you decide if you can afford a refinance? There's more than just interest to consider -- costs and fees add up quickly, and they could wind up nearly wiping out the benefit of a slightly lower interest rate.
Some of the costs to keep in mind when thinking about a refinance include the following.
Private mortgage insurance (PMI). Whether or not you pay PMI depends on your loan-to-value (LTV) ratio. Generally, a LTV ratio of 80 percent or more requires PMI. So if you're taking out an $80,000 loan on a home that's worth $100,000, you'll need PMI.
The cost of PMI reduces the initial savings on a refinance, but it also helps you lock in a lower interest rate long-term. In some cases, you can cancel PMI when you reach 20 percent equity in your home.
Average cost: Generally 1 to 2 percent of the outstanding loan amount divided by 12.
Points. The lower your interest rate, the more you'll pay in closing costs and "points." Paying points generally makes the most sense if you're planning to stay in your home for a long time -- it can take 5 or more years for the money you save in interest to match the cost of the points.
Average cost: 1 percent of the loan amount per point.
Title insurance. Title insurance can be the most expensive of all the costs associated with refinancing. When you refinance you'll have to take out a new policy to protect your lender from any liens or other issues that have arisen since you originally purchased the property.
If you're refinancing with a different lender, it will need a title policy that names it instead of your original lender.
Special pricing, called a reissue rate, is available for homeowners who are refinancing and meet certain requirements. Your lender may not offer it up front so be sure to ask about it -- you could save nearly half the cost of your new title policy.
Average cost: Varies widely from state to state.
Prepaid costs and lender fees. Depending on the day you close, you'll have to prepay the interest you owe from the day of closing through the end of the month. This amount gets added to your closing costs.
If you close on the first of the month, you'll have 30 days of prepaid interest due at closing. You may also have to prefund your tax and insurance escrow. Lender fees can include everything from application fees, attorney review costs, appraisal fees and origination fees, among others.
To make sure you're getting the most affordable refinance, shop around at a few different lenders and compare their costs line by line before making your decision. Remember, you don't have to stick with your original lender during a refinance.
Average cost: According to online mortgage marketplace LendingTree, consumers should expect to spend from 3 to 6 percent of the principal loan amount on closing costs and fees.