Did You Buy a Home With a High Mortgage Rate? Here's How to Know if It's Time to Refinance

Many homeowners who bought homes in 2023 have mortgage rates of 7% or more. Rates peaked at about 8% on the average 30-year mortgage in October 2023, and this caused many buyers to accept mortgage payments that are -- to put it mildly -- higher than they'd like.

Fortunately, mortgage rates have started to retreat from the highs. As of the latest data, the average 30-year mortgage rate has fallen to 6.78%, and mortgage giant Fannie Mae expects this trend will continue, calling for 5.8% rates by the end of the year. This begs the question -- when should homeowners with 7% and higher mortgage rates start to consider refinancing?

How quickly can you refinance?

In many cases, you can refinance as soon as it makes sense. If you bought when rates peaked at around 8% in October 2023 and can now get a loan with a 6.5% rate, refinancing could certainly be an option for you.

Let's take a quick look at the rules. Note that these only apply to rate-and-term refinances, where your only goal is to lower your interest rate. Cash-out refinances often have longer waiting periods (known as "seasoning" rules).

Conventional mortgages have no waiting requirement. You might not be able to refinance with the same lender for six months, but you can certainly shop some of the other top refinancing lenders. FHA loans also have no seasoning requirement for simple rate-and-term refinances. VA loans have to wait at least 210 days (about seven months) before a loan can be refinanced. And USDA loans require a six-month history of on-time payments.

The mathematics of mortgage refinancing

The basic idea is that you need to make sure not only that refinancing will lower your monthly payment, but that the savings you'll get will justify the cost of refinancing.

If you've never done it before, you might not realize that refinancing isn't free. Your new loan will have closing costs, just as when you took out a loan to purchase your home. So, you need to make sure that the savings justify the expense.

Let's look at a simplified example. We'll say that you have a $400,000 mortgage with a 7.5% interest rate that you obtained a few months ago, with a monthly principal and interest payment of $2,797. If you refinance at 6.5%, it would drop your monthly payment to $2,528, a savings of $269 per month.

Now let's say that the loan has $5,000 in closing costs. Dividing $5,000 by your $269 in savings per month would result in about 19 months until you saved enough money to break even on the cost. But to make refinancing worthwhile, you'd need to stay in the home significantly longer than your break-even cost, so keep this in mind when you're crunching the numbers.

Of course, this is a simplified example. For one thing, refinancing closing costs are generally rolled into the new loan (so the new loan would have a balance of $405,000 in this case). And this doesn't consider that you're refinancing with a new 30-year term, so you'll be paying your mortgage for a little longer than with your original loan. But this is often a smart way to help determine if refinancing could be a good idea.

As a general rule, if you can refinance with a new mortgage with an interest rate that is at least 75 basis points (0.75%) lower than your existing rate and you plan to stay in the home for at least five years, refinancing could be a smart option. But like most financial decisions, every situation is different.

What if you refinance and rates go even lower?

One common question I get is, "OK, refinancing makes sense now, but what if I refinance and then rates quickly drop even further?"

It's important to know that refinancing doesn't necessarily have to be a one-time thing. For example, let's say that you bought a home last year with a 7.5% mortgage rate and you've done the math and it makes sense to refinance at 6.5% now. We'll also say that rates continue to fall and reach 5.5% by the end of this year, which would make your payment even cheaper.

There's no rule that says you can't refinance again if market conditions become even more favorable. As I mentioned earlier, many lenders won't let you refinance with them a second time within a certain timeframe, but you can certainly shop around. I know several people who refinanced more than once as rates plunged in 2020 and 2021. The same could certainly make sense for many homeowners today if we see a sustained drop in rates this time around.

The bottom line is that if you're going to be in your home for a while and your expected savings significantly outweigh the cost of refinancing, it could be worth looking into. Homeowners who bought in the past year and a half or so may want to keep an eye on mortgage rates this year to watch for opportunities.