Thinking of Refinancing if Interest Rates Fall? You Need This First

All things considered, now isn't a particularly good time to refinance your home loan. Mortgage interest rates climbed over the course of 2022, and according to Freddie Mac, as of this writing, we're sitting at an average rate of 6.43% for a 30-year fixed-rate mortgage. Plus, mortgage refinance rates are likely to be even higher than those for a new purchase. But if a home loan refinance could be on the horizon for you if and when rates start to fall, will you qualify?

Per the credit bureau TransUnion, a general rule of thumb for refinancing your mortgage is that you must have at least 20% equity in the home. Let's take a look at how home equity works and a few reasons you might consider refinancing when rates fall.

What is home equity, anyway?

One of the benefits of owning a home is that as you make payments on your mortgage loan, you build home equity. Home equity is defined as the amount of your home you own, as opposed to what is still owned by the bank that loaned you the funds to purchase the home in the form of a mortgage.

For example, let's say your home is currently worth $250,000 and you still owe $200,000 on it, having made $50,000 worth of principal payments. In this instance, you'd have 20% equity in your home, and if you wanted to refinance, you might be able to based on that rule of thumb we discussed earlier. But if you had only paid $25,000 on your loan to this point, you'd be sitting at just 10% equity and may not qualify to refinance. But why would you want to?

Why refinance?

There are a few reasons to refinance your mortgage. If you're struggling with how high your payments are, refinancing to a lower interest rate will reduce them, and so will changing the terms of your mortgage. For example, if you have 20 years left on your 30-year mortgage, you can spread the remaining amount owed across a new 30-year period.

You might also decide to change your mortgage type with a refinance. If you bought with an FHA loan and made a low down payment (3.5%), you would have been required to pay mortgage insurance premiums (MIP). If you've now reached 20% equity in the home, you might want to refinance to a conventional loan and save yourself the cost of that mortgage insurance.

You can also refinance to convert an adjustable-rate mortgage to a fixed-rate one. This will leave you with a set interest rate as opposed to one that changes every year after the initial fixed term of five or seven years.

How can you boost your home equity?

Generally, as you make payments on your home loan, your home equity will increase. If you want to help the process along, you can consider paying more on your mortgage, such as by making larger payments every month, making extra payments, or sending occasional extra money to the loan (such as a tax refund or work bonus). Improving your home (say, by remodeling or making upgrades) can also boost its value and therefore your equity.

Finally, if you're not yet a homeowner but want to ensure you go into the mortgage with equity, make a higher down payment. Making at least a 20% down payment will save you from paying private mortgage insurance (PMI) on a conventional loan. But the more money you can put into a home purchase, the more equity you'll have from the beginning.

If you're hoping to refinance your loan when we start to see lower mortgage rates, have a look at your equity by comparing how much you still owe on the house. If you don't have 20% equity but have a strong credit score, TransUnion notes that you may still be able to refinance. Shop around with refinance lenders and see what your options are based on your situation.