After owning your home for some time, you might start to consider whether or not you should refinance your mortgage.

If interest rates have dropped considerably as they have in recent years, or if your credit has improved dramatically, it’s possible you might be able to get a much better deal on a new mortgage than your original loan. Before you commit to refinancing, however, make sure you realize the implications of doing so.

The Realities of Refinancing a Mortgage

To begin with, refinancing can eat away at your home’s equity because refinancing is not free. A refinancing entails paying off your old loan and replacing it with a new one, and banks aren’t in the business of making loans free of charge.

Even if you hear lenders talk about a so-called “no cost” refinancing, don’t believe it. A lender might not have an application fee, or charge you points to refinance, but those costs and others associated with refinancing are essentially priced into a loan with a higher interest rate. As you’ve heard many times before, “There’s no such thing as a free lunch.”

A Refinance Doesn’t Offer as Many Tax Deductions As You May Think

You probably remember that points you pay to obtain a mortgage are tax deductible. When you refinance, however, any points you pay must be amortized over the life of the loan. In other words, you can’t take the full deduction for the points in one year, as you can do when you buy a house.

Avoid These Home Refinance Pitfalls

As with a home equity loan, you should never refinance into a larger loan than is necessary. Unfortunately, scores of homeowners do this all the time when they sign on the dotted line for a “cash out” refinance, which allows you to not only get a better rate or more favorable loan terms, but which also allows you to get some dollars back in the deal as well.

A cash out refinancing saps equity from your home, so you should only take that money if you plan to use the proceeds wisely. Guard against frequent refinancing, too. If rates drop a half point or even a full percentage point, do the math to figure out if any monthly savings you can generate will really outweigh the closing costs and other fees associated with a refinance.

I can’t help but wonder if many consumers are really just cheating themselves out of the opportunity to build wealth due to excessive refinancing.

Don’t Refinance Your Way Under Water

Consider these facts: In recent years, nearly nine out of 10 consumers who refinanced their home loans took cash out in the transaction. In 2006 alone, Americans cashed out $352 billion worth of home equity – more than a 10-fold increase in the amount cashed in the year 2000.

Moreover, when the Joint Center for Housing Studies (JCHS) at Harvard released its annual survey of housing, called the “State of the Nation’s Housing 2007,” the results were especially sobering. The JCHS report indicated that 13% of individuals and families who bought homes in recent years (in 2003 and 2004, to be exact), already had “negative equity” or were “under water” in their homes.

This means their outstanding mortgage debt exceeds the market value of the houses in question. Unfortunately, the news is even worse for more recent buyers.

Multiple Refinancing “Deals” + a Real Estate Downturn = Negative Equity

A November 2007 survey by Zillow found that nearly 16% of homebuyers who purchased houses in 2006 had negative equity, as did 17.5% of those who bought in 2005. As real estate prices continued to fall through late 2009, the number of homeowners facing negative equity now stands at 23%, according to First American CoreLogic, a real estate information company.

Therefore, as of early 2010 roughly 1 in 4 U.S. homeowners are “upside down” or their mortgages and owe more on their homes than the homes are actually worth.

Remember Your Due Diligence

As with all financial products, you should shop around for the best loan terms you can get in the event you decide to refinance your mortgage.

Don’t just accept the first offer that comes your way. In considering a refinancing, follow the same vigilant standards you used to evaluate lenders and their offerings when you bought your house. This means you should know the annual percentage rate on your new loan, all fees charged, as well as key payment terms, such as whether a prepayment penalty exists.

Don’t ever sign any loan documents that you don’t understand and don’t agree if any loan officer or mortgage broker asks you to put your signature on a blank document with the promise that he or she will fill it in later. You don’t know what they could insert into those loan documents.

Also, make sure you get copies of everything in connection with a new mortgage, including a Good Faith Estimate, a Truth in Lending form, as well as the mortgage, note, and/or promissory document you must sign.