In the old days, homeowners bought a house and signed on to a 30-year fixed rate mortgage at the local Savings & Loan. The loan was paid off when the homeowner either sold the house or lived long enough to make 30 years of payments (or possibly less than 30 years if the homeowner decided to make extra payments here and there). In the early 1980s, sky-high inflation caused mortgage rates to rise rapidly. My first mortgage in 1983 was at 13.75 percent. I considered myself lucky to avoid the 16 and 17 percent rates that were common just a year or two before. As rates started to come down over the 80s, homeowners that were stuck with the high rates figured they would be better off to refinance. Until then, refinancing was frowned upon, seen as a move of desperation for those who needed extra cash. Refinancing to insure lower rates was born.

As rates started to decline, adjustable rate loans (ARMs) became more popular. With rates high but bound to come down, adjustable rates were seen as an advantage over conventional 30-year fixed rates. Indeed, adjustable rate loans were slightly lower than fixed loans. I lived in my first condo for only 5 years and never bothered to refinance. The mortgage rate on my second condo was an ARM with a rate of 9.75 percent. I lived there for a much longer period of time - and refinanced my mortgage at least three times over a 10-year period. In addition to the ARMs, my loans included a 20-year loan (instead of the normal 15- and 30-year options) as well as a biweekly mortgage loan (where payments made every two weeks instead of once a month generated an extra monthly payment over the 52 week period and allowed quicker repayment). Mortgages were no longer plain vanilla and came in many flavors.

Refinancing activity tends to accelerate in a period of low and falling interest rates. While many homeowners have become accustomed to a variety of mortgage loan options - including several adjustable rate loans - there is no question that the 30-year conventional fixed rate loan appears to be the favorite, particularly among risk-averse individuals. Refinancing activity has skyrocketed in the past couple of years, surpassing the heady days of the 80s as well as the early 90s.

Watch out for hidden costs
Typically, homeowners refinance to generate lower monthly payments. One of my friends recently mentioned that she always focused on the rate and monthly payment. She financed her place a couple of times and managed to reduce her monthly living costs. It didn't occur to her at the time that each mortgage was re-amortized over a 30-year period. Thus, each time she refinanced, her loan period lengthened. While short term interest costs might be reduced, long term interest costs are reduced less because the loan period is set back to "start again".

How did my friend solve this dilemma? Now that her monthly payments are reduced substantially, she can afford to make twice as many payments in a month and still pay off her loan before the 30-year period is up. The lower monthly payment, however, improves cash flow and offers a homeowner more options than the larger payment.

Incidentally, lower interest costs also mean that your itemized deductions may be reduced. While paying off a mortgage early actually saves a homeowner more money than a simple tax deduction, keep this in mind when you are planning and managing your annual tax bill.

The safe option isn't always the best option
Life's circumstances are always changing. My husband and I purchased our duplex with the intention to live in it for at least 10-years. Plans have changed and it now looks as though we will move out of state within the next two or three years. Since we had a 6.75 percent mortgage rate on our 15-year loan, it didn't make sense to refinance to a similar-type loan because the rate differential was too small (about 75 basis points). However, by getting a 5-year ARM, our mortgage rate was decreased by 1½-percentage points. (A 5-year ARM means that the rate is fixed for five years, but then adjusts every six months or every year for the remainder of the 30-year loan.) At the same time, amortizing the loan over 30 years rather than 15 years also caused a significant reduction in the monthly payment. As a result, our tenants pay for the lion's share of our mortgage. If the housing market slows to a trickle when we are ready to move and sell the property, our monthly out-of-pocket costs would be small.

We considered a shorter-term ARM for an even lower mortgage rate. In switching to a 5-year ARM instead of a 3-year ARM, for example, we gave ourselves some leeway in our moving plans. Furthermore, the 3-year ARM had higher upfront closing costs (for some reason) that didn't apply to the 5-year loan. (The 3-year ARM would offer a fixed rate for 3-years, but adjust every six months or annually for the remaining life of the 30-year loan. Usually, lenders offer some caps on the annual and lifetime adjustment of the loan.)

While the 15-year loan we initially got allowed a quicker pay down of our mortgage, the current loan offers us greater flexibility. For instance, we found that we enjoy real estate investments and would like to increase our income-property holdings. By putting the cash in a money market account that previously went to our mortgage, we will be able to quickly save enough for a down payment on another income-generating property.

Rates can change quickly
Homeowners have been refinancing at a rapid clip over the past couple of years as rates have fallen sharply. The new trend may not be down, but up. In September, the yield on 10-year Treasury notes averaged 3.87 percent. In less than two weeks, 10-year Treasury note yields have gained 67 basis points from their lows. Luckily, mortgage rates have not yet increased that fast. Current rates on 30-year fixed rate loans are roughly 6.25 percent. But given the recent run-up in rates, it's likely that mortgage rates will soon follow suit.

BOTTOM LINE
Interest rates have fallen dramatically these past couple of years. Many homeowners have benefited by refinancing their mortgage loans to reduce rates and monthly payments. Most consumers are risk-averse and would rather get 30-year fixed rate loans than adjustable rate loans. In many cases, the fixed rate loan is a better option.

However, not everyone's life circumstance is the same. In some cases, significantly lower rates can be achieved by garnering a 3- or 5-year ARM. If your plan is to move within that time frame, why bother with the 30-year (higher rate) loan?

It is important to keep in mind that refinancing is not for everyone. If you do plan on moving within the next year, the costs of refinancing will outweigh the benefits by a wide margin. Just keep paying the old loan even if it seems ungodly to pay 7 or 8 percent on a mortgage. For those homeowners who have lived in the same home for several years, remember that a new loan brings you back to "start". It might be better to get a 15-year loan, otherwise you will be paying interest for a lot longer than originally planned.

No one is sure whether the recent run-up in rates will last. To some extent, the rate hikes have come about because stock prices have begun to rally in the past few weeks. But consider this, given that we are in an economic recovery and rates were at their lowest levels in more than 40 years, chances are good that interest rates will rise in the next few months, rather than fall. If you haven't considered refinancing your home until now, get to it!

Evelina M. Tainer, Chief Economist, Econoday