Rate and Term Refinance: Trade In Your Mortgage for a Better Model

A rate and term refinance can lower your mortgage rate or reduce or extend the time you'll be paying off your loan.

Hal M. Bundrick, CFPSeptember 9, 2020
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Rate and Term Refinance: Trade In Your Mortgage for a Better Model

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A rate and term refinance is a loan improvement. You exchange your old mortgage for a new one that (hopefully) leaves you in a better financial position.

You may be able to accomplish one or more goals with a rate and term refinance, such as:

  • Lowering your monthly payment.

  • Reducing the amount of interest you pay over the long term.

  • Building equity in your home and paying it off faster.

  • Changing the type of loan you have, from an adjustable-rate to a fixed-rate mortgage or an FHA to a conventional loan, for example.

  • Eliminating mortgage insurance.

When to consider a rate and term refinance

Several situations might prompt you to consider a rate and term refinance. Mortgage rates moving significantly lower might be one. Having an adjustable-rate mortgage approach the end of its initial fixed-rate guarantee could be another.

Other scenarios that might present an excellent opportunity to refinance your home loan to a better rate or a different term include:

When your credit score improves or you start to make more money

With a higher credit score than when you closed your current loan, you may earn a lower mortgage rate. Or, if your earnings increase, you may opt to shorten the loan term to pay off your mortgage faster.

When the break-even point matches your plans

Consider the time it will take to recoup the costs of a refinance with how long you intend to remain in your home. That determines your refinance break-even point. If your break-even point falls well within your stay-here plans, a refi might make sense.

Some borrowers also look to a rate and term refinance when they're trying to time the payoff of their mortgage with retirement.

When you have at least 20% equity in your home

Mortgage insurance is a fee you pay to protect the lender's interest in your home loan. In many cases, mortgage insurance can be eliminated once you have 20% equity, and refinancing is one way to make that happen.

Some borrowers also look to a rate and term refinance when they're trying to time the payoff of their mortgage with retirement, says Christopher Sailus, a vice president with WaFd Bank in Seattle.

Rate and term vs. cash-out refinancing

The primary difference between a rate and term refi and a cash-out refinance, other than the money you pocket, is this: A rate and term refi maintains or reduces your current amount of housing debt. A cash-out refi, where you take some of the equity out of your home, increases your debt.

However,  you can draw some cash out of a rate and term refinance, without it being considered a cash-out refi. Generally, it's 2% of the loan value or $2,000, whichever is less, Sailus says.

"You have to have no more than $2,000 coming back to you at closing to keep the loan as a rate and term refinance," adds Derrick Strauss, branch manager of Planet Home Lending in Denver.

"You can roll in your closing costs and escrows — those don't count toward the $2,000 limit. The $2,000 limit is just the money you receive at closing."

When is refinancing to a lower rate worth it?

Strauss suggests doing a little math to see if a refi is right for you.

"To see your savings, compare the cost of all the monthly payments you have left on your current home loan to all the monthly payments on the new loan. Be sure to add the cost to refinance when totaling your new loan costs," Strauss says.

Rate and term refinance guidelines and costs

With what is called "loan-level pricing," borrowers with a loan-to-value ratio of 65% or less get the best deals, Sailus says. However, lenders may approve refinance loans for borrowers with up to 80% loan-to-value, sometimes even as high as 95%, he adds.

A minimum credit score of 620 is preferred by rate and term refinance lenders, though lower scores are not always disqualified, according to Sailus.

What are the costs of a rate and term refinance? You could pay 2%-5% in closing costs for a refinance. That's another good reason to shop a few lenders to see who offers the best combination of mortgage rates and low fees.

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