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Rate-and-term refinance: What it is and how it works

Yahoo Personal Finance· Getty Images
Updated 9 min read

When homeowners think about refinancing a mortgage, they don’t always distinguish between various refinance options. A traditional refinance, known as a “rate-and-term refinance” or “non-cash-out refinance,” refers to refinancing a mortgage into a new loan with a new interest rate. You’ll also have different loan terms, such as the length of the loan and whether the rate is fixed or adjustable.

This is in contrast to another common form of refinancing, “cash-out” refinancing, which refers to refinancing your existing loan into one with a higher balance to access your home equity as cash.

To decide whether refinancing is right for you — and which type of refinancing makes sense — it’s essential to understand how a rate-and-term refinance works.

In this article:

A rate-and-term refinance refers to a mortgage refinance based on the outstanding balance of your loan. It’s probably what you think of as a standard refinance.

Your new mortgage will likely have a different mortgage rate, and you will start with a new loan term, such as a 15-year or 30-year mortgage. In addition, you may choose to refinance into a new type of loan, such as refinancing from an FHA loan to a conventional loan or from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage.

Learn more: 5 ways to prepare for a refinance

While both rate-and-term and cash-out refinancing involve replacing your existing mortgage with a new home loan, there are differences between the two processes.

The main distinction between a rate-and-term refinance and a cash-out refinance is that you are not tapping into your home equity with a rate-and-term refinance. Instead, you’re refinancing into a loan that might have a lower balance since you will have paid off some of the mortgage principal on your previous home loan. Your new balance depends on how long you have been making payments on your mortgage.

Cash-out refinancing gives you access to your home equity in the form of a larger mortgage, typically up to a maximum of 80% of your home value. Generally, a cash-out refinance will have a slightly higher mortgage rate than a rate-and-term refinance since lenders take on extra risk when you borrow more money.

Learn more: How a VA cash-out refinance works

Generally, rate-and-term refinancing is more popular when interest rates decline since borrowers want to take advantage of reduced mortgage rates and potentially lower their monthly mortgage payments. The Consumer Financial Protection Bureau found that cash-out refinancing was more popular than rate-and-term refinancing when rates were rising.

In addition to these two common types of mortgage refinancing, some borrowers with FHA, VA, and USDA loans are eligible for Streamline Refinancing that requires less paperwork.

Occasionally, borrowers opt for “cash-in” refinancing, which means they pay money at closing to lower their loan balance for the new loan.

Dig deeper: FHA cash-out refinance — Requirements and guidelines

The main benefit of a rate-and-term refinance is the ability to take advantage of lower mortgage rates to reduce the interest you pay on your home loan. However, you can accomplish other goals with a rate-and-term refinance even if mortgage refinance rates are not lower than when you first took out your current loan.

Here are some goals you could accomplish with a rate-and-term refinance:

  • Lower monthly payments toward your principal and interest. Your monthly payments will be smaller if you qualify for a lower interest rate. Even if mortgage rates are not significantly lower, you may be able to reduce your monthly payment if you have substantially paid down your loan balance and choose another 30-year mortgage term.

  • Build equity faster. Shortening your mortgage loan term from 30 years to 20, 15, or 10 years can accelerate your loan payoff date and build equity more quickly.

  • Eliminate mortgage insurance. Suppose your home has increased in value or you have paid down the balance, so you have at least 20% equity. In that case, you can lower your monthly payment even more by refinancing into a conventional loan and ending private mortgage insurance (PMI) payments. Remember that you don’t necessarily need to refinance to get rid of PMI. Your lender should have a process to cancel it when you have enough equity.

  • Reduce the overall interest you pay. If you lower your mortgage rate or shorten your loan term, you can spend significantly less on mortgage interest over the life of your loan, depending on the balance and the difference in rate.

  • Switch your mortgage loan type. FHA loans generally require you to pay FHA mortgage insurance for the entire loan term, so you may want to consider refinancing into a conventional mortgage to remove FHA insurance premiums. If you have an ARM and are worried about mortgage rates rising, you could choose a fixed-rate loan for payment certainty.

Dig deeper: How to get the lowest mortgage rates

You can use a mortgage calculator to estimate the monthly payments on a rate-and-term refinance, but you’ll also need to find out from a lender how much your refinance will cost. Generally, closing costs for a rate term refinance are 2% to 5% of your loan amount, and you may have the option to roll those costs into the new mortgage. You can shop around and talk to various mortgage lenders to compare loan costs.

If your rate-and-term refinance saves you money on your monthly payments, determine how long it will take to make up for the money you spent on your closing costs. For example, if your closing costs are $8,000 on a $400,000 mortgage loan and you are saving $250 monthly on your mortgage payment, it will take 32 months to recoup the $8,000. In this case, 32 months is your breakeven point.

Your breakeven point is an important calculation because if you think you will sell your property before you recoup your closing costs, it may not make sense to refinance.

Learn more: How soon can you refinance a mortgage?

Several scenarios may make it advantageous to apply for a rate-and-term refinance, such as:

  • Mortgage rates have dropped below your current rate.

  • Your credit score has improved, and you can qualify for a better mortgage rate.

  • Your income has increased, and/or your debt is lower, so you can qualify for a lower mortgage rate.

  • You have paid down your loan balance significantly and want to reduce your monthly mortgage payments or pay off your house faster.

  • You have cash flow issues or anticipate a tighter budget, so you may benefit from refinancing into a new 30-year loan with lower payments.

  • You expect your ARM rate to increase and would rather lock in a rate with a fixed-rate mortgage.

  • You want to change your loan term to coordinate the payoff date with your anticipated retirement.

Dig deeper: Is now a good time to refinance your mortgage?

While a rate-and-term refinance can benefit you in many ways, there are times when it may not be the best decision, such as the following:

  • Mortgage rates are substantially higher than your current rate. A mortgage calculator can estimate your new payment at current rates based on your remaining loan balance and the closing costs to see if refinancing is beneficial.

  • You plan to sell your home soon. Because refinancing is expensive, it rarely makes sense if you plan to move within a year or two.

Learn more: A guide to USDA streamlined refinance loans

If you apply for a rate-and-term refinance, you’ll need to qualify based on a lender’s guidelines. The process is generally similar to applying for any other mortgage.

Most mortgage lenders require a minimum credit score of 620 or higher for a rate-and-term refinance, although you will qualify for a lower rate on a conventional loan if your credit score is higher. Lenders typically require a debt-to-income ratio (DTI), which compares your minimum monthly payments on recurring debt with your gross monthly income, to be 50% or less, preferably under 43%.

Your lender will also review your income, assets, credit history, and home value. Most lenders prefer that you have at least 20% in home equity to refinance, although there are loans out there available for homeowners with less equity. If you have less than 20% equity, you will need to pay mortgage insurance on the loan.

Read more: How a VA streamline refinance (VA IRRRL) works

Generally, you need to wait at least 12 months after the closing on your original mortgage to apply for a rate-and-term refinance.

Yes, many mortgage lenders allow you to roll your closing costs into your refinance so the amount is instead added to your new mortgage principal. This is also known as a no-closing-cost refinance.

With a rate-and-term refinance, you are refinancing the remaining balance of your current loan. With a cash-out refinance, you access the equity in your home and add it to the remainder of your current loan, which means your total loan balance will increase.

Conventional lenders typically prefer you to have at least 20% in home equity for a rate-and-term refinance. FHA lenders allow you to refinance one FHA loan into another or a conventional loan into an FHA loan with just 2.25% in home equity. However, you would be required to pay mortgage insurance for the entire loan term.

This article was edited by Laura Grace Tarpley