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A rate-and-term refinance is a way to swap out your current mortgage with a new loan that improves your mortgage terms. You might consider this type of refinancing to lower your interest rate and monthly payment or to pay off your home faster. Additionally, a rate-and-term refinance can help you eliminate mortgage insurance or to change your loan type.
Before you begin the process, it's essential to understand what a rate-and-term refinance is, how it works, and when you may want one.
How a Rate-and-Term Refinance Works
Some lenders refer to rate-and-term refinances as "traditional refinances" or "no-cash-out refinances." No matter the name, a rate-and-term refinance allows you to get a new loan—ideally with more favorable terms—and pay off your original loan. In doing so, you can change your interest rate and loan term while your principal balance remains the same.
By refinancing for a lower mortgage rate or shorter loan term, you could potentially save thousands of dollars over the course of the loan. Say, for example, you have 20 years remaining on a variable-rate mortgage, and your outstanding balance is $200,000 at 7% interest with a $1,859 monthly mortgage payment. By refinancing with a new 15-year mortgage at a fixed 5%, you could forego the interest rate hikes that accompany adjustable-rate mortgages and pay off your home five years earlier. You'd also lower your monthly payment to $1,788 and save over $105,000 in interest over the life of the loan.
When to Consider a Rate-and-Term Refinance
Several circumstances may motivate you to consider a rate-and-term refinance as a way of improving your financial position, such as:
- When the market rate drops or your credit score improves: If your credit is better now than when you took out your original loan, or if market rates fall, you may qualify for a lower interest rate. Not only will you save money on interest charges, but you'll also create more room in your budget with a lower monthly mortgage payment.
- When interest rates on your adjustable-rate mortgage (ARM) rise: Consider a rate-and-term refinance if you have an adjustable-rate mortgage nearing the end of its introductory fixed-rate guarantee period. Swapping out your ARM for a fixed-rate mortgage may allow you to safeguard against rising interest rates and more expensive payments.
- When your income amount changes: If your income is improving and you can afford a higher payment, you may be eligible to refinance into a shorter-term loan. Not only will you pay off your mortgage sooner, but you'll also save money on interest charges. Conversely, you may want to extend your term to lower your monthly payments if you make less income. Remember, the longer you make mortgage payments, the more interest you'll pay over time.
- When you have 20% equity in your home: Conventional loans allow you to cancel private mortgage insurance (PMI) when you have at least 20% equity in your home. If you meet this requirement, but you have an FHA or USDA loan, you may be able to get rid of mortgage insurance by refinancing into a conventional loan.
While a rate-and-term refinance can help you in many situations, they're not a cure-all for every circumstance. For example, you might not want to refinance your mortgage under the following circumstances:
- When you won't live in your home long enough to break even: You'll need time to recoup your new loan's closing costs, which can range from 2% to 5% of the loan amount. If you don't plan on living in your home long enough to break even, then a rate-and-term refinance may not be your best option.
- When your mortgage rate is already low: If a new mortgage rate only lowers your existing rate by less than 1%, your savings may be insignificant, especially after you factor in the closing costs.
Rate-and-Term vs. Cash-Out Refinance: When Should You Consider One Over the Other?
In most cases, getting a rate-and-term refinance is a better financial move than choosing a cash-out refinance. That's because you can trade your current mortgage for a new one with favorable terms, ideally. And you may be able to qualify with below-average credit because you're borrowing against your home's worth, a less risky proposition for your lender.
By contrast, with cash-out refinances, you're cashing out your home's equity, which will likely result in less favorable lending terms than a rate-and-term refinance. Not to mention, the cash you take out is added to your mortgage balance. That's more money for which you must now pay interest charges.
Nevertheless, a cash-out refinance is one way to access a large sum of money at relatively low interest rates to pay down debts, fund a home improvement project or achieve other goals. If you're already planning on using home equity toward different objectives, interest rates on a cash-out refinance are often lower than with a home equity loan or home equity line of credit (HELOC).
How to Get a Rate-and-Term Refinance
Getting a rate-and-term refinance is similar to the process when you took out your first mortgage loan. You must submit an application and financial documentation to your lender, who will then consider your income, creditworthiness and other factors to approve or deny your loan.
Here's a quick breakdown of the steps and requirements for this refinance:
- Apply for your refinance. It's always wise to shop and compare mortgage rates from multiple lenders before applying to ensure you're getting the best value. Once you've selected a lender, fill out a refinance application and be ready to submit supporting documents, like recent pay stubs, bank statements and W-2s.
- Lock in your interest rate. After you submit your application, you should receive a formal loan estimate from your lender. This document will outline key features of your loan, including your interest rate, repayment term and fees. You can also lock in your mortgage rate for 30 to 60 days to safeguard from interest rate changes while your loan is processing.
- Get a home appraisal. For most refinance loans, lenders will schedule an appraisal of your home to determine the current market value of your property, primarily based on its condition and the final selling prices of similar homes in your area.
- Review and understand your closing disclosure. Shortly before closing, you should receive a closing disclosure that finalizes the projected closing costs detailed in the loan estimate. Compare the terms in the closing disclosure against the loan estimate terms to ensure they match up. Make sure you completely understand and agree to the terms of your new loan before signing for it.
- Close on your loan. Once you confirm the terms on your loan disclosure are correct, it's time to close on your loan. Typically, you'll meet with your lender, discuss loan details and sign your documents. You'll also pay for any closing costs that aren't included in your loan. After you sign your loan documents, you'll enter a three-day rescission period when you can cancel your loan if necessary.
Check Your Credit Before Applying
Lenders often have minimum credit score requirements you must meet to qualify for a rate-and-term refinance. Knowing where your credit stands before refinancing can give you an idea of whether it might be best to take your time to improve it.
Get access to your credit report and credit score for free with Experian. Review your report for negative or incorrect information that could hurt your chances of approval for a new loan, and see what steps you can take to improve your credit. Dispute any errors you find with the appropriate lender or credit bureau, who must correct or delete information they find to be unverifiable or inaccurate.