Mortgage rates have dropped. Should you refinance your home?

Mortgage rates have dropped significantly in recent months, and that means one thing for those who bought a home in the last couple years: It might be time to refinance.

Refinancing your mortgage means swapping your current interest rate for a new one. This is typically done if rates have fallen a good amount since you took out a home loan or last refinanced. The average rate for a 30-year fixed-rate mortgage is now just above 6%, down a full point from where it was in May.

Most homeowners won’t feel the need to do anything. Nearly 60% of Americans with mortgages have rates below 4%. But if you bought recently at a higher rate, you could now be in a position to cut your monthly payment significantly.

Even small changes in rates can make a big difference, says Rohit Chopra, director of the Consumer Financial Protection Bureau, a U.S. government agency. “Now that rates have been falling, we project that millions of people can save big money every month if they're able to refinance,” he says.

For example, on a $500,000 mortgage, you'd save $329 on the monthly payment with a 6% versus a 7% rate.

Interested in seeing if you can save money on your mortgage? Here’s what to know about refinancing – and how to think about timing.

Get a sense of how much you could save

The first step is to do some online research to get a rough idea of how a lower rate could change your monthly payment. You’ll also want to:

• Calculate your refinance rate. Websites like Bankrate, Nerdwallet and Rocket Mortgage have pages where you can enter basic data like your zip code, credit score range and how much you owe on your loan, and they’ll spit out sample refinance rates from various lenders. This will give you a more specific idea of the sort of rates you might be able to get.

• Calculate your break-even point. Plug your rate into an online refinance calculator to get a sense of your break-even point: how long you would need to own the home before the savings from refinancing outweigh the costs of refinancing. If you’re planning on selling your home soon, it might not make sense to refinance.

Refinancing does cost money: expect to pay several thousand dollars in closing costs, as you did when you first bought the home. Benjamin Balser, a mortgage broker in Alexandria, Va., says refinance costs for a typical home in Washington, D.C., tend to start at about $2,000, while in Virginia, they’re upward of $3,000.

Keep in mind that these online calculators are only giving you an estimate. To get results tailored to you, you’ll need to reach out to some mortgage brokers and loan officers. Which brings us to the next step.

Shop around for the best rate

When you refinance, you could stick with your current lender or go to a new one. The new lender pays off your old mortgage when you take out your new loan.

To get the best rate, shop around for quotes. Ask your friends, coworkers and neighbors to connect you to their lender and get rates from them.

Getting the best rate is partly a numbers game, says Sam Khater, chief economist at Freddie Mac.

“Even identical borrowers applying on the same day with the same lender will often get different rates – and it's hard to figure out why,” he says. “You just have to make sure you get enough quotes, because one of them may come in that's lower than the others.”

One possible alternative: a mortgage reset

There’s also an alternative to refinancing that may be available, depending on your lender: a mortgage reset. Some banks and credit unions allow you to reset your mortgage rate to the current market rate, often for a flat fee, without having to jump through the hoops of a refinance.

Ask your lender if this is an option, because it won’t be for all mortgages.

Refinancing means a new loan with new possibilities

People often refinance to lower their monthly mortgage payment. But there are other reasons you may want to go through this process.

• To move from an adjustable rate mortgage to a fixed rate mortgage. Borrowers who have a variable rate may want to lock in a rate they know they can manage.

• To borrow money. Some people who have built up equity in their home opt to do what’s called a cash-out refinance, where they take out a larger loan than what they currently owe on their property.This allows them to take out cash by tapping into their home equity. This is commonly done to pay for home renovation projects as an alternative to using a home equity line of credit (HELOC). A cash-out refinance can also be used to pay down other debt at a higher rate.This type of refinance comes with risk. It means taking out a bigger loan, and it reduces the equity you have in your home.

Consider the loan term you want

Because refinancing means taking out a new loan, the loan term can be changed.

If you are two years into paying off your 30-year mortgage, you have 28 years left on it. But if you take out a new 30-year loan, you’re starting the 30-year clock over again. That can be a little dispiriting.

If your financial situation has improved or the new lower rates make it possible, you could see about moving to a shorter-term loan, like 15, 20 or 25 years. A shorter term means paying off your mortgage faster and paying less total interest.

Ask potential lenders what terms are possible, and assess what your monthly payment would be.

Figure out when to jump

When mortgage rates are moving around, it’s hard to know when to refinance. Should you go for it as soon as it’s clear it’ll save you money? Or should you wait to see if rates drop further?

Your decision to refinance depends on your personal circumstances as a borrower, for example, how long you intend to own the home. But if the numbers are in your favor now, Khater says he’d go for it.

“Forecasting rates is very difficult. There's a lot of turbulence, both in the financial markets and in geopolitics that could drive rates higher from here. From my perspective, I would take the opportunity and pull the trigger.”

In other words, if you can save $300 a month by refinancing now, he says you might as well hedge your bets and do it. If rates fall another full percentage point, you could always refinance again later.

And you may not realize this, but as a homeowner, you’re already paying for the option to refinance. It’s baked into the mortgage rate you’re paying -- the risk to your lender that you may decide to refinance your loan someday. So take advantage of it if it can save you money.

Additional resources

Freddie Mac’s refinancing guide

Nerdwallet’s refinancing guide

The audio portion of this episode was produced by Margaret Cirino. The digital story was edited by Malaka Gharib and Chris Arnold. The visual editor is Beck Harlan.

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