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A rate and term refinance is a new mortgage that improves your loan terms. With a lower interest rate or a new loan timeline, you may be able to save money, pay off your loan quicker, or make your monthly payment more affordable. A rate and term refinance is different from a cash-out refinance in that you won’t receive cash at closing.
Here’s what you need to know about rate and term refinances:
- How rate and term refinances work
- Rate and term refinance requirements
- Benefits of rate and term refinance
- Drawbacks of rate and term refinance
- Rate and term refinance vs. cash-out refinance
- How to get a rate and term refinance
- Should you get a rate and term refinance?
How rate and term refinances work
When you refinance your mortgage, you get a new loan — with new terms — and pay off the original loan. There are several types of refinance loans from which you can choose. A rate and term refinance, also known as a traditional refinance or no cash-out refinance, allows you to change the interest rate and loan term without changing the principal balance.
Homeowners generally use a rate and term refinance to achieve one or more of these goals:
- Secure a lower mortgage rate. Check to see if you qualify for a lower refinance rate, which can help you reduce your monthly payment and save on interest costs.
- Change the loan term. When refinancing into a shorter loan term, you pay less interest over the life of the loan and get out of debt quicker — but your monthly payment will increase. Refinancing to a longer loan term, on the other hand, may increase your overall interest costs while lowering your monthly payments. This could help you avoid foreclosure if you’re struggling to pay your bills.
- Switch loan types. If you have an adjustable-rate mortgage and the initial rate period expires soon, you might decide to move to a fixed-rate loan. This can make payments more predictable.
- Eliminate mortgage insurance. With a conventional mortgage, you can eliminate private mortgage insurance (PMI) when you have at least 20% equity in your home. This may be a good idea if your home value has recently increased. If you have an FHA loan or USDA loan and enough equity, you can shed mortgage insurance by refinancing into a conventional loan.
Rate and term refinance example
Before applying for a rate and term refinance, it’s a good idea to figure out what your monthly payment will look like.
For example, let’s say you bought a home three years ago for $400,000 with a 20% down payment and a 4% interest rate. The principal and interest payment on the original loan comes out to $1,526 per month.
By refinancing into a new loan with a 3% interest rate, you would lower your monthly payment to $1,349. That saves you $177 per month and $36,598 over the life of the loan.
| Interest rate | Monthly principal and interest | Total interest paid over loan term | Interest saved |
|---|---|---|---|
| 4.0% | $1,526 | $230,226 | - |
| 3.0% | $1,349 | $193,628 (interest paid on original loan and new loan) | $177 per month and $36,598 over new loan term |
Rate and term refinance requirements
Just as when you applied for your original loan, you’ll need to meet your lender’s refinancing requirements. Fortunately, rate and term refinances are generally easier to qualify for than cash-out refinances because the equity requirements are less stringent.
Here are the other general requirements for a rate and term refinance:
- Adequate home equity
- Strong credit
- DTI ratio
- Home appraisal
Adequate home equity
When applying for a refinance, requirements vary by loan type. You’ll need at least:
- 2.25% equity to refinance an FHA loan
- 3% to refinance a conventional loan owned by Fannie Mae
- 5% to refinance a conventional loan owned by Freddie Mac
Generally, having more equity can help you get a better interest rate and potentially forgo private mortgage insurance.
Strong credit
A conventional loan typically requires a credit score of at least 620, while you may qualify for an FHA refinance loan with a lower score. If your credit has improved since closing on the original mortgage, you might qualify for a better mortgage rate.
DTI ratio
Your debt-to-income ratio (DTI) measures how much of your monthly income goes toward debt payments. While there’s no set criteria for a refinance loan, lenders usually look for a DTI ratio of no more than 43% for conventional loans.
If your earnings have increased, you might also consider shortening the loan term in the refinance — as long as you can afford the higher payments.
Home appraisal
When you apply for a rate and term refinance, your lender may schedule an appraisal to determine your home’s value. They want to make sure they aren’t giving you more money than your home is worth.
A low appraisal may hurt your chances of qualifying for the refinance. But a high appraisal can help you secure the new loan and potentially get rid of private mortgage insurance.
Benefits of a rate and term refinance
A rate and term refinance may help you:
- Build equity and pay off the mortgage sooner. Some homeowners refinance into a shorter loan term — for instance, from a 30-year to a 15-year mortgage — to accelerate their payoff timeline. This may help you build equity quicker and get out of debt sooner.
- Save on interest. When you shorten your loan term, get a lower interest rate, or both, you could save on total interest costs over the life of the loan.
- Lower your monthly payment. Securing a lower interest rate or extending your loan term could help you lower your monthly mortgage payment. This frees up room in your budget.
- Make payments more predictable. An adjustable-rate mortgage comes with an interest rate that may change after a certain period of time. If you have an ARM, then refinancing into a fixed-rate loan can help you avoid rate increases and higher monthly payments.
Drawbacks of a rate and term refinance
Even if you benefit in some way from a rate and term refinance, they may come with some drawbacks. A rate and term refinance may:
- Extend your payoff timeline. You have the option of refinancing to the same term as your original home loan or refinancing into a longer term. These options help lower your payments, but you’ll be paying off debt longer.
- Cost money upfront. You may save money on a refinance, but closing costs on these transactions typically reach $5,000. Take your monthly savings and divide the number by the closing costs, which will help you figure out how many months it takes to break even.
- Increase your loan payment. Refinancing into a shorter-term loan will drive up your monthly payments. This can help you save on interest, but make sure the payment fits within your budget.
Rate and term refinance vs. cash-out refinance
A rate and term refinance and a cash-out refinance both allow homeowners to take out a new mortgage and change the interest rate, loan term and loan type. But homeowners have an extra option with a cash-out refinance: tapping their home equity to borrow money.
With a cash-out refinance, the homeowner gets a new loan for more than they owe, pays off the original mortgage and pockets the difference. The extra money can go toward anything, such as debt consolidation or home improvement projects.
| Rate and term refinance | Cash-out refinance |
|---|---|
| No cash at closing | Will receive cash at closing |
| Doesn’t increase debt | Increases your debt |
| May need up to 5% equity in home to qualify | May need 20% or more equity in home to qualify |
| Monthly payments may decrease | Monthly payments will increase |
How to get a rate and term refinance
Preparing for a new mortgage loan and understanding the steps involved can help you get through the process easily. Here’s a broad overview of how to get a rate and term refinance:
- Figure out why you’re refinancing. Setting a goal can help you find the right lender and figure out if refinancing is worth the effort. For instance, ask yourself if you want to reduce your monthly payment, change your loan term, switch to a fixed rate, or get rid of mortgage insurance.
- Check your financial standing. Lenders will look at your credit score, DTI ratio, and home equity to see if you qualify for a refinance. You may decide to work on these areas before applying for a new loan.
- Compare lenders. To see which offers the best deal, get a rate quote and closing cost estimate from multiple lenders.
- Calculate your breakeven point. Based on the closing fees and how much you’ll save each month, figure out when you’ll recoup your upfront costs.
- Apply for the loan. This process is similar to the first time you took out a mortgage. You’ll need to agree to a credit check, hand over your financial documents, and go through the underwriting process.
Should you get a rate and term refinance?
Rate and term refinancing is a good option for homeowners who are hoping to take advantage of lower interest rates and don’t need to borrow money at closing. According to mortgage data firm Black Knight, refinancing is a good idea if you can shave at least 0.75% off your original interest rate or lower your monthly payment.
But it’s not just about how your monthly payment changes. The costs of refinancing a home typically reach $5,000, so you’ll have to calculate your break-even point.
If you’re considering a rate and term refinance, be sure to compare offerings from different lenders to get the best possible deal. Credible can help you compare actual prequalified rates from all of our partner lenders, and it takes just minutes.
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