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With a Fed rate cut on the table this week, some homeowners who bought in recent years may consider taking advantage of declining mortgage rates to lower their monthly payments.

Asaf Bernstein

The average rate on a 30-year fixed rate mortgage is at its lowest rate since April 2023 at 6.38% as of Sept. 6, according to the Mortgage Bankers Association (MBA). The Federal Reserve will make its next rate decision Sept. 18 and has signaled it will lower benchmark rates by a quarter point to a half point. A fed funds rate cut, which would be the first since March 2020, could lead to lower borrowing costs, luring some homeowners to refinance and bringing buyers back into the market.

If you’re considering refinancing, proceed carefully. According to Asaf Bernstein, associate professor of finance at Leeds School of Business, refinancing decisions are complex, and the risk of not getting it right can cost homeowners tens of thousands of dollars. Bernstein shares his take on the matter with CU Boulder Today.

What refinancing missteps should homeowners be aware of in this interest rate environment?

The path of interest rates is a huge driver of whether interest rate cuts are going to do what you expect them to do. Let's say that interest rates have been steadily falling, and then there is another interest rate cut. Now you have an incentive to refinance to reduce your monthly mortgage payment, both because you’re extending the maturity and because the interest rate is reduced. That gives your household more money. If you're the Federal Reserve and want to encourage spending, this is the goal.

But let's say that interest rates have been rising for a while, as they have in the past few years, and then the Fed cuts rates. Everyone is still sort of locked in at very low rates. It’s still not going to incentivize most people to refinance. Maybe there's a subset of people where the maturity extension would reduce their monthly payment enough that they'll refinance even though it's a bad deal from an interest rate perspective. 

You may hear from a mortgage company or lender or broker that you should think about refinancing. But not refinancing optimally is one of the biggest financial mistakes households make. Suboptimal refinancing can leave huge amounts of money on the table.

So the danger is in misinterpreting what the Fed rate cut could mean for you?

If the Fed says it’s going to cut rates, you shouldn’t run out and refinance no matter what. 

You don't want to get tricked into thinking you should refinance when you shouldn’t. It’s attractive only if you didn't refinance when rates were falling.

Sub-optimal refinancing happens when people basically refinance to reduce their monthly payment but it ends up pushing up their interest rate. Even if it ends up doubling their rate, they might actually see a lower monthly payment because it just kicks the maturity down the road. 

It's a very complicated thing, but probably not a good financial decision for households in most cases. 

How do you know when the time is right to refinance?

The reality is, refinancing is a confusing process. You need to have a credit score that makes it feasible. It also costs money to refinance—it’s pretty expensive. So what if you refinance now and then rates fall again next year? If rates fall again in three years, then it was probably worth doing now because you saved all that money. 

For borrowers, it's complicated. This is where government regulation could play an important role. Now that we're in this environment where rates have risen and are falling again, it becomes even more complicated in some ways. Do you make a move now or later? Where are rates going to go from here?

It seems impossible to know whether this is the time to refinance or enter the market and buy that dream house. For the average household, it's a very tough time to be in the market. And it's never been harder, in some sense, to buy a house relative to median incomes.

As we've moved interest rate environments, it's a re-education and a challenge that everyone's facing. Any competent and trusted financial advisor should be helpful for households trying to sort out refinancing decisions.