​​Mortgage Rate Cuts Loom: Here's How to Know You Should Refinance

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Homeowners, would-be buyers, and potential sellers are heaving a collective sigh of relief. The high rates that have been choking the housing market for the past few years might finally be easing. This month, average 30-year mortgage rates slipped below 6.5% for the first time in a year.

The Fed looks set to reduce the federal funds rate at its upcoming September meeting, which may cause mortgage rates to drop even further. But do rate cuts mean you should refinance? That depends on a lot of factors, including how much you might save, why you're refinancing, what closing costs you'll pay, and how long you plan to stay in the property.

How to know if you should refinance

Refinancing is essentially swapping your current mortgage for a new one. It won't make sense for everybody. For starters, if you locked in a mortgage at around 3% in 2021, your rate would be higher if you refinanced today. Refinancing may also extend the term of your home loan, which isn't always the right move long-term.

Knowing if you should refinance depends a lot on why you're doing it. If you're taking a rate-and-term refinance to capitalize on lower rates, you can calculate how much you'd save and decide from there. If you want to use a cash-out refinance to tap the equity in your home, consider what you're using the money for and how much debt you're taking on.

Here are some questions to answer.

1. Can I qualify for a significantly lower rate?

There are a few factors that impact the rate a mortgage lender will offer you. Putting the wider economy to one side, your financial situation also matters. Find out whether your credit score is as high (or higher) than when you took out the original mortgage. If it has fallen, see if there are steps you can take to increase your score before you refinance.

You might be wondering how big your rate drop needs to be to justify a refinance. There's a lot of mixed advice out there. Ultimately, today's high house prices mean that even a 0.5% rate drop can translate into some decent savings. The big caveat is that you need to weigh those savings against any closing costs.

Let's say you bought a house last year and got a 30-year mortgage with a rate of 7.5%. Average rates are now at 6.5%, so you might be able to lower your mortgage by 1% with a rate-and-term refinance. Here's how the math works out on a $400,000 property with $100,000 down.

2. What closing costs will I pay?

Just as with your original mortgage, you'll need to pay closing costs when you refinance your loan. Even if you take out a no-closing-cost refinance, the fees will be reflected in a higher rate or added on to your principal.

If we look at the example above, snagging a mortgage rate of 6.5% instead of 7.5% could reduce your overall costs by around $72,500. You'd also reduce your monthly costs by about 10%. Here's the kicker: Closing costs on a refinance can come to between 2% and 5% of the loan.

For the $300,000 rate-and-term refinance above, that would come to between $6,000 and $15,000. You'll often be able to roll the fees into your overall loan costs, but it's important to include them in your calculations.

3. How long will I stay?

If you're planning to move in the next couple of years, refinancing your mortgage may not make sense. Think about how long you'd need to stay in the home to cover those closing costs. For example, if you cut your monthly costs by around $200 and pay $10,000 in costs, it would take just over four years to break even.

4. What loan term will I take?

Another common reason to refinance is to shorten your mortgage term. If you have a 30-year mortgage and rates fall considerably, you might opt to refinance to a 15-year mortgage. Switching to a 15-year term can dramatically decrease your total costs. However, it will likely also increase your monthly payment.

For instance, the monthly principal and interest payment on the 7.5% 30-year loan above is almost $2,100. If you were to refinance to a 15-year term at 6.5%, the payment would increase to just over $2,600. But you'd save over $200,000 in total interest payments over the course of the loan.

If you go this route, you need to be confident you'll be able to make the higher payments. Otherwise you risk defaulting on your mortgage.

Refinancing can be a powerful financial move

There's no simple answer to the question of whether you should refinance. Consider why you're refinancing and explore the different options and what they might mean for you. Compare rates with different mortgage refinance lenders and work out how long it will take you to break even.

Ultimately, if you do the math and it makes financial sense for you, you have your answer.

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