What’s A Rate-And-Term Refinance And How Does It Work?

Ready to lower your interest rate or make your mortgage payments more affordable? A rate-and-term refinance might be the answer.

Just like it sounds, a rate-and-term refinance gives you a new loan with a different interest rate and loan term. Let's go over the inner workings of a rate-and-term refinance so you know whether refinancing can offer you the right game plan moving forward.

What Is A Rate-And-Term Refinance?

First, what is a refinance?

A refinance means you trade your current mortgage for a newer one, and your lender uses the newer mortgage to pay off the old one. In the end, you wind up with just one loan and one monthly payment.

Now, what is a rate-and-term refinance? A rate-and-term refinance can be a useful tool for homeowners looking to lower monthly payments or decrease their interest rate. Unlike other types of refinance options, a rate-and-term refinance keeps the loan principal the same, but allows you to change the interest rate, the length of the loan or both.

When Should You Get A Rate-And-Term Refinance?

First, consider your overall goal. What do you ultimately hope to achieve when you make changes to your mortgage?

Two main reasons may come to mind: paying off your mortgage faster or decreasing your mortgage payment. A rate-and-term refinance can do more than that, however. It can help you switch to a fixed-rate mortgage or eliminate mortgage insurance.

• Lower your interest rate: Your interest rate is the amount you pay in interest on top of your principal loan balance. A lower interest rate automatically translates to paying less in interest over your loan term, which can amount to thousands of dollars.
• Extend your loan term: When you extend your loan term, you also decrease your mortgage payment, which results in a lower monthly payment.
• Shorten your loan term: Shortening your loan term means that you take less time to pay off your loan. For example, you might refinance from a 30-year mortgage to a 15-year mortgage.
• Refinance to a fixed-rate mortgage: A fixed-rate mortgage is a mortgage in which the interest rate stays the same. In an adjustable-rate mortgage (ARM), the interest rate changes.
• Eliminate mortgage insurance: You can refinance to remove private mortgage insurance (PMI), which is an insurance that you pay each month to protect your lender when you put down less than 20% on your loan. You can also get rid of the FHA mortgage insurance premium (MIP) that you pay with an FHA loan using a rate-and-term refinance.

Pros And Cons Of Rate-And-Term Refinance

It's worth considering the pros and cons of a rate-and-term refinance before you ultimately contact your lender about this option.

Pros Of Rate-And-Term Refinance

What are the benefits of a rate-and-term refinance? Let's go over them.

• The ability to shorten your loan term: Shortening your loan term means that you can potentially take years off the life of your loan. For example, shortening from a 30-year loan to a 15-year loan shrinks the number of payments you'll make over the course of the loan term, leading to a quicker payoff.
• The ability to change to a fixed-rate mortgage: Switching to a fixed-rate mortgage means that you move from an ARM (which might be more unpredictable) to a stable, potentially lower interest rate. Doing so might save you money in the long run.
• Lower monthly payments: You can lower your monthly payments by extending your loan term. For example, you might switch from a 15-year to a 30-year loan, which would most likely keep your payments smaller and more manageable.
• Lower your interest rate: Lowering your interest rate can save you thousands over the course of your loan. An interest rate calculator can show you just how much you might be able to save if you lower your rate.

Potential Cons Of Rate-And-Term Refinance

It's important to consider the downsides of a rate-and-term refinance as well:

• Potential to increase payoff time: While it gives you smaller monthly payments, lengthening your loan term can add years to your payoff time frame. This means you would likely pay more in interest over your loan term.
• Being subject to higher interest rates: If you refinance at a time when your interest rate is higher than when you took out your original loan, you may pay more in interest over the life of your loan.
• Paying more closing costs: You will have to pay closing costs when you refinance. Closing costs will typically cost you between 3% – 6% of your total loan balance. For example, with a $300,000 mortgage, you could pay between $9,000 – $18,000 in closing costs, so ensure you budget for that.

How To Get A Rate-And-Term Refinance In 5 Steps

Getting a rate-and-term refinance doesn't have to be complicated at all, and if you're not sure about what to do at a certain point in the process, your lender will answer your questions.

1. Make Sure You Qualify

Will you qualify for a refinance? Give yourself a little checkup to find out.

First, you'll need to meet basic criteria, including meeting your lender's credit score qualifications. Your credit score tells your lender about your debt repayment track record and how likely you are to repay your new mortgage in the future. You'll need a credit score of at least 620 to get a conventional loan, whereas FHA rate-and-term refinance guidelines typically carry lower credit requirements. Check with your lender for their guidelines.

You'll also need to have a debt-to-income (DTI) ratio that fits your lender's requirements. Your DTI shows how much money you spend on monthly debt versus your income. You can calculate it by adding up your minimum debt payments and divide the total by your pretax income per month. Consider keeping your DTI below 50%.

Finally, consider the amount of home equity you have in your home. The amount of home equity you have in your home can determine whether you can get rid of PMI or not. You must reach 20% equity to refinance and remove PMI.

2. Apply With A Lender

When you apply for a refinance, you'll find this process very similar to when you originally bought your home. Your lender will ask for similar information, such as information about your income, assets, debt and credit score. They might also ask for your pay stubs, W-2s, bank statements, tax information and more. They need to verify all your financial information to ensure that you have a high likelihood of repaying your loan.

3. Schedule A Home Appraisal

Your next step involves getting a home appraisal before refinancing your mortgage. A third-party professional appraiser estimates the value of your home in a refinance appraisal to determine whether your home has appreciated or depreciated since you purchased it.

They compare your home to recently sold homes in the area to determine the fair market value of your home. It's the same appraisal process you would have experienced when you first purchased your home.

Appraisals also help lenders understand whether you meet their loan-to-value (LTV) requirements. Your LTV is the sum of the outstanding balances for all liens against the appraised property value. You can calculate it by dividing the new loan amount by the market value of your home.

4. Close On Your New Mortgage

Closing on your new mortgage involves bringing people and documents together – anyone listed on the loan documents, a title company employee and possibly a witness.

You'll also need to gather essential documents and materials, such as:

• Your driver's license or other government-issued identification
• Cashier's check for closing costs
• Closing Disclosure from your lender, which you should check for mistakes

Most refinances close within 30 – 45 days after you apply. Come prepared with any questions you have, and it shouldn't take long to complete.

If you have a change of heart, you can take advantage of a grace period (3 business days) to back out of or change your refinance.

5. Pay Using Your New Terms

Finally, you'll make your monthly payments using these new terms. Your new mortgage statements will reflect the new terms through your mortgage servicer. 

Additional Mortgage Refinance Options

When deciding whether you should refinance your mortgage, note that there are several refinancing options available to you besides a rate-and-term refinance.

Cash-Out Refinance

A cash-out refinance means that you borrow money against your home's equity. The equity in your home is the amount you officially own and have paid down. In a cash-out refinance, you receive a new mortgage larger than your current mortgage balance. Your lender pays off your original mortgage and you receive cash that makes up the difference between the two loans.

Here's how it might work. Let's say you want to put a pool in at your home, which you've calculated would cost $60,000. You owe $230,000 on your $350,000 home.

$230,000 + $60,000 = $290,000

Your new mortgage amount would be $290,000. Your lender would then give you $60,000 for the new pool.

You typically must have at least 20% of equity in your home to qualify for a cash-out refinance, but that's contingent on your lender's requirements.

FHA Streamline Refinance

An FHA Streamline refinance helps homeowners with FHA loans change their interest rate or loan term. You may lower your interest rate, shorten (or extend) your loan term and reduce monthly payments.

You can undergo an FHA Streamline refinance more quickly than other underwriting processes because lenders don't require full underwriting. Your lender may not have to verify your credit score or income, and you may even get around the appraisal process.

No-Closing-Cost Refinance

When you refinance using a no-closing-cost refinance, you don't have to pay the closing costs when you refinance your loan. You'll still pay closing costs, they just roll right into your principal amount or you receive a higher interest rate. The major advantage is that it saves you from having to save up tons of money for closing costs when you simply want to refinance.

Learn more with our no-closing-cost refinance guide.

VA IRRRL Streamline Refinance

A VA IRRRL Streamline refinance is a VA Streamline loan offered by the Veterans Administration. "IRRRL" stands for "interest rate reduction refinance loan," and it's a great way to benefit financially from a refinance.

Similar to an FHA Streamline refinance, a VA Streamline makes the process easier, but you must currently have a VA loan. You can switch from an adjustable-rate mortgage (ARM) – one that moves from an adjustable rate to a fixed rate, lowers your monthly interest rate and mortgage payments or changes loan terms.

To qualify, you must also:

• Wait 210 days before you can apply.
• Receive an immediate financial benefit – lenders require your new loan to present a clear financial benefit.
• Live in a home that is your current or previous primary residence – you cannot use it for a new investment property.

The Bottom Line

Ultimately, it's a good idea to consider your overall financial goals before you decide to get a rate-and-term refinance. Great reasons to consider a refinance involve lowering your interest rate, extending your loan term, shortening your loan term or refinancing to a fixed-rate mortgage. The right type of refinance can also help you achieve your goals.

Ready to refinance? Start the mortgage refinance process today.