What Is a Rate-and-Term Refinance?

A rate-and-term refinance changes the interest rate, the term, or both the rate and the term of an existing mortgage without advancing new money. This differs from a cash-out refinance, in which new money is advanced on the loan. Rate-and-term refinances often carry lower interest rates than cash-out refinances.

Key Takeaways

  • A rate-and-term refinance changes the interest rate, the term, or both the rate and the term of an existing mortgage without advancing new money.
  • Rate-and-term refinancing activity is driven primarily by a drop in market interest rates, while cash-out refinance activity is driven by increasing home values.
  • If a borrower's credit has improved substantially, that borrower may be able to refinance at a lower interest rate.

Understanding Rate-and-Term Refinance

Rate-and-term refinancing activity is driven primarily by a drop in market interest rates, while cash-out refinance activity is driven by increasing home values. Because there are advantages and disadvantages associated with both rate-and-term and cash-out refinancing, the borrower must weigh the pros and cons of each before making any final decisions.

Benefits of Rate-and-Term Refinancing

The potential benefits of rate-and-term refinancing include securing a lower interest rate and a more favorable term on the mortgage, but the same principal balance will remain. Such refinancing could lower the homeowner's monthly payments, or potentially set a new schedule to pay off the mortgage more quickly. There are several ways to exercise a rate-and-term option.

Requirements for Rate-and-Term Refinancing

For rate-and-term refinancing to work, lower interest rates must be available to the borrower. There are two main reasons why this might not be the case. The first reason is that interest rates in the overall economy can go up as well as down. There are many factors influencing interest rates that the borrower has no control over.

However, borrowers do have some control over their consumer credit. If a homeowner has defaulted on credit cards or mortgage payments, that homeowner will probably face higher interest rates. These personal factors are usually more important than market interest rates. If a borrower's credit has improved substantially, that borrower may be able to refinance at a lower interest rate.

If a borrower's credit has improved substantially, that borrower may be able to refinance at a lower interest rate.

Rate-and-Term Refinancing vs. Other Options

Cash-out refinancing takes equity from the home for the homeowner to use. It works best when the overall value of the property has increased because of rising real estate values. However, cash-out refinancing can also be done if the homeowner is well along in the mortgage and has paid in a significant part of its equity. In the process, a cash-out refinancing will increase the principal owed on the mortgage.

This refinancing might call for a reappraisal of the home to gauge its new value. Homeowners might seek such refinancing to gain access to capital from the value of the house, which they otherwise might not see until the home was sold.

A converse option called cash-in refinancing involves putting more money toward the settlement of the mortgage to reduce any remaining principal.

When considering any of these options, it is important to calculate all the implications carefully and see how they compare to keeping your current mortgage.

Examples of Rate-and-Term Refinancing

Upon seeing interest rates drop, for example, a homeowner who has been paying off a 30-year mortgage for 10 years might want to take advantage of the new rates. One option would be to refinance the balance left on the original mortgage at that lower rate for a new 30-year full term. The new loan would have lower monthly payments, but it would be like starting over at a lower rate. It would add 10 years to the total time to pay off the mortgage. There were 10 years spent paying the first mortgage, and there would be another 30 years for the new one, which would equal 40 years in total. Between the lower interest rates and the longer term, monthly payments would be much lower.

The homeowner could also use the rate-and-term refinancing option to pay the new interest rate and negotiate a 15-year mortgage. The monthly payments would be twice as high as for a 30-year term, all other things being equal. Since interest rates fell, the monthly payments may be lower than they were for the remaining 20 years of the original mortgage.

More likely, monthly payments would still be higher because of the shorter term. The main advantage is that the homeowner would save five years of payments. There were 10 years spent paying the original mortgage, and there would be 15 years for the new one, which would equal 25 years in total.