A rate and term refinance, also known as a traditional refinance, allows you to change your interest rate, your loan length, or both. The refinance creates a new mortgage that pays off your existing mortgage. A rate and term refinance is different from a cash-out refinance, which puts money in your pocket upon closing.
Let’s review rate and term refinances, how they work, and their differences from cash-out refinances.
Definition and Examples of Rate and Term Refinances
After purchasing a home and acquiring a mortgage, you’ll begin paying back your loan. The amount you owe each year is called your mortgage debt service, and any payments that you make will reduce your total debt. These will vary based on the type of loan that you have, but all mortgages require payments consisting of both principal and interest.
Once you have your first mortgage, you may be eligible for a refinance. Refinancing is the act of applying for and getting approved for a new loan. You’ll then receive an entirely new mortgage, and your new loan pays off the old one. Next, you will complete payments in installments toward your new mortgage.
Different types of refinancing options are available; one is a rate and term refinance. The goal of this type of refinance is to change either the rate or the term of your existing loan—or both. You may wish to lower the interest rate if rates have dropped, or you might want to extend the duration of your loan to reduce your monthly payments.
Much like an original mortgage, there are expenses associated with refinancing, including closing and financing costs, though these can usually be rolled directly into the new loan.
In the case of a rate and term refinance, you don’t receive any money at the time of closing. This is because you don’t withdraw any money from your home’s equity, as would happen in a cash-out refinance.
- Alternate name: traditional refinance, no-cash-out refinance
How Rate and Term Refinances Work
Let’s say that you and your spouse purchased a home in 2005, long before the recession battered property prices and interest rates. You went for a standard loan with a 20% down payment and a 30-year term. However, it’s now 2021, and you’ve both been paying off this loan for the last 16 years. After doing a little research, you find some information online about how mortgage interest rates are near all-time lows—far lower, in fact, than the one you’re currently paying.
You both still work and have a stable income, though you’re very interested in lowering your mortgage payment. Although you’ve gained equity in the house since you’ve bought it, you’d prefer to just pay off what you owe, rather than taking any money out.
Rate and term refinances can be used to shorten your loan’s length.
In this case, a rate and term refinance may be a good option for you. Lowering your interest rate can save you thousands of dollars in interest over the life of your loan, while changing your loan term can help cut your monthly payments.
You still owe $100,000 on your original mortgage, and you have 14 years left in which to finish paying it off. If you were to use a rate and term refinance to create another 30-year loan, however, you’d instead owe $100,000 due over a period of 30 years. Because you’d have more than twice the time to pay off the same amount of money, you’d be able to take advantage of much lower monthly payments. This decision, however, is likely to add to the total amount of interest you’ll pay over the life of the refinanced loan.
Rate and Term Refinances vs. Cash-out Refinances
|Rate and Term Refinance||Cash-out Refinance|
|Ability to change both rate and term||Ability to change both rate and term|
|Replaces previous mortgage||Replaces previous mortgage|
|Does not allow you to withdraw equity||Allows you to withdraw equity from your home and add to your loan balance|
Although rate and term refinances and cash-out refinances may look similar overall, their main difference arises from the total amount of your new loan.
A rate and term refinance does not add any further debt to your loan—aside from closing costs, if you choose to include them. A cash-out refinance, meanwhile, gives you the opportunity to withdraw any equity from your property in the form of a cash payment.
- A rate and term refinance can be used to alter the interest rate, the length of your mortgage, or both.
- You cannot withdraw equity from a rate and term refinance, unlike with a cash-out refinance.
- Whether you use a rate and term refinance or a cash-out refinance, a new mortgage replaces your existing one.