The pluses, the pitfalls and a step-by-step outline of how to refinance your home loan.

There's never been a better time to switch to a new loan or lender. Exit fees have been banned on home loans taken out after July 1, fixed rates are tumbling and lenders are aggressively competing for your business. By shopping around you could find a cheaper rate or better loan features — and both could see you enjoy big savings. But there are also traps to avoid. Without careful research, refinancing could leave you out of pocket.

Reasons to refinance

"Refinancing" simply means paying out your old loan by replacing it with a new one. Along with the chance to secure a cheaper rate, other reasons to refinance your mortgage include accessing better loan features, tapping into home equity or consolidating debt.

HSBC head of mortgages Alice Del Vecchio says, "Feedback from HSBC customers in Australia indicates many people refinance to us because their lender doesn't make them feel special enough — or special at all."

Even if you're happy with your lender's rate and service, at some point you may need to refinance.

This being the case, it's worth knowing what's involved in switching lenders.

First port of call, your current lender

If you're refinancing purely to get a better interest rate, it can be worth approaching your current lender for a rate reduction or the option to switch to a cheaper "basic" loan. This may be the only option available if you don't have reasonable equity built up in your home.

Next, check your home equity

Before you start looking at what other lenders have to offer, it's essential to have a clear idea of your home equity. This is the difference between the balance of your mortgage and your home's current market value — something a real estate agent can estimate free of charge.

As the property market has cooled in recent months, you could find your home equity is below the 10% benchmark if you bought in the boom or used a small deposit to secure the property.

If you want to avoid paying lenders mortgage insurance (LMI) on the new loan, you'll need at least 20% home equity. LMI premiums can cost as much as 2% of the property's value, so without reasonable home equity, you could be better off staying put.

LMI isn't portable between lenders, so it will still apply even if you paid a premium when you purchased the property. Insurer Genworth has a calculator that can estimate LMI.

Rather than refinancing, you may want to increase your loan to access home equity. But it may not be as simple as it sounds thanks to the new responsible lending laws.

Will exit fees apply?

If you've had your current loan for less than five years, there's a good chance your lender will impose exit fees when you discharge the mortgage (exit fees do not apply on new loans taken out after July 1, 2011).

TIP: The government's Money Smart website has an online calculator that can help you work out whether you'll save money by switching.

Adding up the cost

Even if you can escape LMI and exit fees, refinancing still involves other costs:

• Mortgage discharge fee, about $250.
  
• Registration of new mortgage, about $300 (varies between states and territories).
• Loan application fees, allow $600. This won't apply if you refinance with a package loan but you will pay an upfront package fee.
• "Break costs" if you're refinancing a fixed rate loan.

On top of this (total $1150), some lenders may charge a settlement fee. And refinancing with your current lender doesn't always save you such costs as some lenders charge a variation fee if you switch from one loan to another. To recoup these costs and make refinancing worthwhile, you need a reasonable rate discount. The good news is that by shopping around you may be able to cut 0.5% off your home loan rate.

Work out your bottom line

Your new lender or mortgage broker should be able to tell you the long term interest savings on a new loan.

To work out how long it will take to recover the costs of switching, divide the total cost of refinancing by the monthly savings on the new loan. For instance, if refinancing costs $1200 but you're saving $100 each month on the repayments, it'll take 12 months to recoup the cost — assuming all aspects of your loan remain the same. The longer it takes to recover the cost, the greater the chance a better deal will come along.

Supersize your savings

Turbocharge the gains from refinancing by using the savings on a new loan to make extra repayments.

Let's say for instance, that Sue and Bill refinance their $400,000 mortgage from a loan charging 7.4% to one charging 6.9%. If the couple opt for a 20-year term (we'll assume they've already had their loan for five years), their monthly repayments would drop from $3198 to $3086 — a saving of $112, and it will take just seven months to recoup their refinancing costs of $1500.

If they maintain their mortgage repayments at the old rate (adding the $112 savings to their loan repayments), Sue and Phil will slash $52,222 off the total interest charge and be mortgage free 1½ years sooner.

Know what you need

In a competitive mortgage market, loans are becoming more flexible. A young couple for example may benefit from a loan offering a maternity repayment holiday. Or if you're keen on a fixed rate, some lenders, such as HSBC, winner in Money's Best of the Best three-year and five-year fixed rate loan category, even give borrowers the flexibility to make extra repayments on a fixed loan.

The key is to shop around. It can help to use a mortgage broker but not all lenders work with brokers so it's worth doing some research of your own and casting your net wide. Websites such as www.ratecity.com.au, www.mozo.com.au and www.infochoice.com.au show rates and features for an extensive variety of loans.

Boost your chance of loan approval

Once you've selected a loan that's right for you, it's time to prepare your application. Responsible lending requirements demand lenders take an in-depth look at a borrower's financial history.

Paperwork you'll need to gather includes: two recent pay slips; two years' PAYG certificates; 12 months' home loan statements; a council rates notice (to confirm the name on your home's title deeds); other loan and credit card statements.

When the "retention team" calls

If you reckon your current lender is going to let you simply wander off to a competitor, think again.

HSBC's Del Vecchio believes consumers are cynical about last-ditch efforts by lenders to salvage the relationship. "It's only when the discharge form appears that a lender starts to offer any love to their customers, and efforts to retain business are often seen as too little too late."

If your current lender makes a strong offer, it's worth considering. But if you're firm about leaving, lenders may try stalling. "Your lender may drag the chain on discharging the mortgage — after all, they have no incentive to let the loan go, and it can take up to six or eight weeks for some banks to release the mortgage," Del Vecchio warns.

Is it worth the effort?

Today's home loan market is brimming with good deals with many loans offering innovative features and flexibility. However it is vital to ensure that refinancing leaves you better off. Even small savings can make the move worthwhile, especially if you use the extra cash to make additional loan payments.

Finally, be very wary of using refinancing to consolidate debt. Unless you are absolutely committed to making additional repayments on the new home loan as well as sticking to a tight spending budget, you could easily find yourself worse off further down the track.

Looking for more renovation advice? Check out our renovation section.