Prediction: When Interest Rates Fall, These Borrowers Should Refinance

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The word on the street is that my bestie Jerome Powell is about to announce a cut to the federal funds rate at the next meeting of the Federal Reserve Board. Although the federal funds rate doesn't directly affect mortgage rates , they do tend to move with it, so potential borrowers can likely plan on seeing rates drop further in September.

For current homeowners, though, it's a bit of a mixed bag. A drop in rates at this point could spell savings for them, or it might just be a lot of cost for a very small gain. Here are some borrowers who should definitely talk to a mortgage lender as interest rates fall.

1. Anyone who borrowed at a 7% interest rate

Most of the people who borrowed their mortgage with an interest rate of around 7% did so between October 2022 and July 2024, though there were certainly several rate dips in that range, too. With such recent purchases, it may make sense to refinance, especially if you plan to stay in your home long term.

But a refinance will generally cost between 2% and 5% of the new loan balance. So, not only do you reset the clock on your mortgage interest (more on that later), you also have to find a breakeven point for when the refinance actually pays for itself and stay on the right side of that. Your best-case scenario comes with paying your note in full.

Let's say you bought a house using a 30-year fixed-rate mortgage for $300,000 with 5% down at a rate of 7.00% in November 2022. Right now, in September 2024, you'd owe $274,048 in principal to the bank. You borrowed $285,000 initially, so you've not made a lot of progress on the principal yet, but you've paid $35,919 in interest.

If you pay this mortgage in full for its lifetime, you'll have paid a total of $397,000 in interest to the bank. However, if you refinance at 6.00% today, and pay the rest of the principal off over 30 years, you'll pay $317,452 in interest, plus the sunk cost of the first mortgage's interest, $35,919, which comes to a grand total of $353,371 in interest paid.

Even adding the cost of the refinance into the mix, let's use 5% as a figure for a worst-case scenario, you're adding just $13,702 to the total interest for both, bringing the grand total to $367,073, almost exactly $30,000 less than if you kept your original mortgage.

2. People who got an FHA loan with less than 10% down

These people are also possibly in a position to do well when interest rates fall. They knew when they bought their house that they'd have to sell or refinance eventually, or they'd pay mortgage insurance for 30 years, but with rates staying stable, there's not been much of an incentive to do so in the last couple of years.

They can't shake their mortgage insurance until their note is at 80% of the value of their home, but this can come from either paying down the mortgage (the old fashioned way) or experiencing booming real estate inflation (a way that's been common recently). This often won't happen until you've been in your home a while, which may mean that this theoretical FHA note has a 3% mortgage, and that likely won't make sense to refinance in the near future.

But as rates drop, a refinance gets a lot better looking, on paper and in the vibe check arena. Let's say rates drop to 5.50%, rather than just 6.00% -- maybe someone with a 3.85% rate would be OK making that move. After all, they're losing mortgage insurance in the deal.

For a borrower who was today refinancing their original 3.85% mortgage of $237,500 from September 2019, they could expect to have just $214,288 remaining in principal. Their base mortgage payment for the existing note was $1,209, including the mortgage insurance.

The refinanced mortgage payment at 5.50%, is $1,216, but there's no mortgage insurance to be seen. Effectively, that payment remains the same, even with the mortgage insurance removed.

If they had paid a lifetime of mortgage insurance, it would have totaled an extra $20,847. Even if it costs about half of that to do the refinance, they're still significantly ahead to refinance away their mortgage insurance if they're staying in their home.

Refinancing is a strategic move in all rate environments

No matter when you choose to refinance your home, you have to look at the numbers, as well as how it makes you feel. Does it feel bad to go from a 3.00% note to a 6.00% one? Of course. But it doesn't always mean it's a bad financial move, depending on the other pieces on the money board.

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