If you are ready to refinance your mortgage, you’ll need to know what type of refinance you need. Lenders have a few options at their disposal, including the rate and term refinance.
The rate and term refinance is the most common type of refinance. As you can kind of tell from the name, the point of the refinance is to change the rate or the term, for the better. With this refinance, you don’t take cash out of the home’s equity. Instead, your mission is to make your payment more affordable or your term lower so that you pay the loan off faster.
Borrowers use this option to decrease their interest rate or choose a more favorable term for their loan. We’ll explore both options below.
Rate and Term Refinance for a Lower Rate
The most common reason borrowers use the rate and term refinance is to get a lower rate. They hear that interest rates dropped and they want a piece of the action. The rate and term refinance leaves your principal balance the same; it just puts you in a different loan.
Let’s say that your loan is with Lender A. But you find out that Lender B will give you an interest rate that is 0.75% lower than what you pay now. You want to jump on board, so you formally apply for the loan with Lender B. Once Lender B approves your loan, you go to the closing table. It’s here that Lender B takes the proceeds of your loan and pays off Lender A. You no longer have a loan with Lender A. You now have a loan with Lender B.
Once payments begin, you will pay Lender B each month. With this new loan, you have a new loan term. This is the length of time you have to make payments to pay the loan in full. You have the option to take a loan term that is identical to your loan term on your original loan or to shorten the term. We suggest that you take a term that is as close to the amount of time you had left on your original loan.
For example, if you had a 30-year loan with Lender A, but you paid 5 years on the loan, you have 25 years left. If you take out another 30-year loan with Lender B, you added 5 years back onto your loan term. Instead, you could see if Lender B will give you a 25-year term. The good news is that you may even be able to lower your rate a little more with the shorter term. The bad news is that your payment may be slightly higher because you decreased the time you have to pay off the loan.
Rate and Term Refinance for a New Term
Some borrowers refinance their loan just to change the term. This is common for borrowers that have an adjustable rate mortgage. If you have an ARM, your rate isn’t fixed. It can change on the change date each year. This means from one year to the next, you don’t know what your interest rate will be. If that’s too scary for you or you want the predictability of the fixed rate loan, may want to refinance into a fixed rate loan.
Some borrowers also refinance their mortgage just to get a shorter term. If you know that you can afford a larger monthly payment, it may benefit you to get that lower term. This is especially true if you can refinance out of a 30-year term into a 15-year term. Essentially, you cut your loan term in half. This means you’ll own your home free and clear in half the time.
What you may not realize is that the interest savings will be the largest benefit. When you cut 15 years off the term of your loan, you could save thousands of dollars in interest. You’ll just have to make sure that the closing costs you pay to get the lower term make sense compared to the amount you’ll save on the interest over the life of the loan.
Cash in Hand With a Rate and Term Refinance
In some cases, you may be able to walk away from a rate and term refinance with a little cash in hand. Most lenders allow you to take as much as $2,000 out of the home’s equity without considering it a cash-out refinance. This sometimes just happens naturally as the lender estimates the closing costs, amount for the escrow account, and any prepaid interest. If there’s money left over and it doesn’t exceed $2,000, you can generally keep the cash rather than using it to pay down the principal of your loan.
The rate and term refinance is the best way to get the lowest interest rate on your loan. If you need to take cash out of your home’s equity, you can expect to pay a higher interest rate and more fees in order to make up for the riskiness of the loan.