In the mortgage world, a “rate and term refinance” refers to the replacement of an existing mortgage(s) with a brand new home loan.
The refinance loan comes with a new interest rate (ideally lower) and a fresh mortgage term, such as another 30 years.
The existing mortgage is effectively paid off by the opening of the new refinance loan, with the old loan balance transferred to the new loan.
Think of it this way – you are re-financing your mortgage, meaning you are obtaining new financing terms for an existing home loan. Some might refer to it as a mortgage “redo.”
The issuer of the new mortgage pays off the old loan with the proceeds from the new loan so everyone is square.
What Is a Rate and Term Refinance?
- The act of replacing your existing home loan(s) with a brand new one
- In order to obtain a lower mortgage rate and/or different term
- Which results in a cheaper monthly payment and possibly interest savings over the loan term
- A product change is also possible, such as refinancing an ARM to a fixed loan
Using my example from the illustration above, our hypothetical homeowner has a relatively high mortgage rate of 5.25%, but current mortgage rates are a much lower 4.25%.
If they chose to refinance their mortgage, it would be a good opportunity to do so to lower their monthly payments significantly.
On a $300,000 loan amount, the monthly payment would fall from $1,656.61 to $1,475.82. That’s nearly $200 in savings each month! And a ton of saved interest over the life of the loan.
When you obtain this new financing, you can either go back to your original mortgage lender or shop around with other banks and lenders.
Generally, it’s best to see what other lenders can offer, instead of simply relying on your original bank/lender.
Either way, when you refinance your home mortgage you are seeking out new financing terms for one reason or another.
It could be to lower your monthly payment, get rid of mortgage insurance, or simply to switch loan types.
Read more: How does mortgage refinancing work?
What type of mortgage refinance are you looking for?
- You can refinance your mortgage for many different reasons
- The most basic option is a rate and term refinance
- Which simply changes your interest rate/term or loan program
- Without affecting the outstanding loan balance
The simplest type of mortgage refinance is called a “rate and term refinance” because the borrower is merely changing the interest rate and term of the loan, and perhaps the loan program, but not the loan amount.
It may also be known as a “no cash out refinance” for this reason because no additional money is being borrowed via the transaction.
So if you owe $500,000 and execute this type of refinance, you’ll still owe $500,000 when all is said and done, but your mortgage payment might differ, along with your lender and loan program.
Typically, a borrower will consider a rate and term refinance if their current mortgage is an adjustable-rate mortgage and the fixed period is due to expire.
Or if mortgage rates have dropped significantly since they originally took out their ARM or fixed-rate loan.
An example would be a 3-year ARM. The first three years are fixed, and then the mortgage becomes annually adjustable, based on the margin and index tied to the loan.
At or before this first adjustment, borrowers will often look into refinancing their mortgage to avoid the impact of the fully indexed rate, assuming it’s higher than the initial rate (which it often is).
These types of loans are rarely held to maturity (or even close to it) because most homeowners don’t like the risk of a variable interest rate.
Even those with a 30-year fixed are unlikely to hold it for more than 10 years before refinancing or selling their property.
Another common reason to refinance is to drop private mortgage insurance, which can be removed once the borrower has 20% or more home equity.
It may also be a good option if your credit has improved significantly since you first took out your mortgage, thereby allowing you to qualify for better terms.
Check out this example of a rate and term refinance:
Loan type: 3-year ARM
Loan amount: $500,000
Start rate: 2.875%
Fully-indexed rate: 4.25% (after 3 years)
Available refinance offers: 3.5% on a 7/1 ARM or 4% on a 30-year fixed
Potential savings: ~$215 per month
Most short-term ARMs are hybrids with 30-year loan terms, with both a fixed and adjustable component.
In the scenario above, the interest rate is fixed during the first three years of the mortgage and adjustable for the remaining 27 years. This is typically represented as a 3/1 ARM.
After the first three years are up, the interest rate becomes the sum of the margin and index, and can adjust once annually either up or down. However, it tends to go up.
Instead of getting stuck with a higher rate, the borrower can seek out new home loan financing that is lower than the fully-indexed rate, whether it’s another ARM or a fixed-rate loan.
Your Mortgage Rate May Rise If You Don’t Refinance
- If you have an adjustable-rate mortgage it might be a necessity to refinance
- Once the initial fixed-rate period comes to an end after 3, 5, or 7 years
- After that time the interest rate could adjust significantly higher
- Making monthly payments unaffordable or simply undesirable
In the example above, if the borrower doesn’t refinance after three years, their interest rate will jump from a low 2.875% to a much higher 4.25%.
There are initial rate caps that may limit the amount the interest rate can actually rise (or fall), but it usually won’t be sufficient to keep the mortgage rate in check in a rising rate environment.
So most borrowers will likely look to refinance their existing loan to a new loan with a longer fixed period and ideally a lower interest rate.
Or simply refinance into another ARM with another initial teaser rate if ARM rates are still attractive.
If you happen to be replacing a fixed-rate mortgage with another fixed-rate mortgage, you may want to shorten the term while you’re at it, assuming you want to pay off the loan as originally scheduled (or ahead of time).
Otherwise you’ll be looking at a fresh 30 years on the new refinance mortgage, and it’ll take much longer to actually own your home outright, assuming that’s one of your financial goals.
Of course, a shorter loan term will require a higher monthly payment in most cases, so it’s not always a viable option for cash-strapped borrowers. An affordability calculator will help you determine this.
Sometimes it’s good enough just to get the interest rate and associated loan payment down to a more affordable level.
As noted, homeowners have the choice of refinancing their existing loan with their current mortgage lender or shopping rates and loan programs with a new bank, lender, credit union, or mortgage broker.
It is always recommended that you shop around when refinancing your mortgage, as mortgage rates, closing costs, underwriting requirements, and loan programs can and will vary greatly from lender to lender over time.
Your original lender may have had the best deal when you first took out your mortgage, but that might not be the case today.
Consider Closing Costs Associated with a Mortgage Refinance
- Aside from the new interest rate and term on the mortgage
- One should also consider the many costs involved
- Which can be quite sizable depending on how the loan is structured
- So much so that they could actually make the decision to refinance a bad one if they aren’t recouped
Although there will be closing costs associated with the new refinance mortgage, the lower interest rate should eventually offset these costs and benefit the borrower in the long run.
This is known as the “break-even point of the refinance” – essentially when the closing costs, things like the origination fee, title fees, and points, are absorbed by lower monthly mortgage payments, so subsequent monthly payments save the homeowner money.
Be sure to include how long you plan to keep the new loan when running the numbers through refinance calculators, otherwise they may assume you’ll hold the loan to term. This can throw off the math considerably.
Think of it this way. If the homeowner stays in their adjustable-rate mortgage at 4.25%, they will pay $2,459.70 a month in principal and interest payments.
If they refinance into a lower priced fixed-rate mortgage, or an even cheaper ARM, say at a rate of 3.5%, they’ll pay $2,245.22 a month in principal and interest payments. That’s a savings of about $215 per month.
Sure, there may be closing costs associated with the refinance mortgage, but the monthly savings will cover those costs over time if they stick with the mortgage.
But if they only keep the new loan for a year or two, those costs may never be recouped.
However, it might also be possible to execute a no cost refinance where you pay no closing costs in exchange for a slightly higher-than-market rate, but still receive an interest rate well below your existing one.
These monthly savings are exactly why a homeowner would opt to apply for a rate and term refinance – to obtain a lower rate and payment relative to their current loan.
Of course, if they only stayed in the home/mortgage for a year or two, perhaps they wouldn’t recoup the costs associated with the refinance.
In that case, it would be a poor decision to refinance. So always take the time to do the math and look ahead to the future before agreeing to anything.
There are plenty of refinance calculators out there that can do the math for you, taking into account mortgage rates, loan term, types of loans, closing costs, and more.
Why Homeowners Refinance Their Mortgages
- To obtain a lower mortgage rate (and save on interest)
- To swap an ARM for a fixed mortgage
- To reduce monthly mortgage payments
- To tap their home equity for cash
- To consolidate combo mortgages
- To consolidate other more expensive debt
- To pay off high-interest rate credit cards and other loans
- To add or remove someone from a loan (spouse or other family member)
- To remove costly mortgage insurance
- To switch loan programs, such as FHA to conventional
- To shorten the loan term and pay off a loan faster (30-year to 15-year fixed)
Tip: Most mortgage lenders will let a borrower take out incidental cash-out of the lesser of 2% of the loan amount or $2,000 – $5,000, and still consider it a rate and term refinance.
Anything beyond that would probably be considered a cash-out refinance, which is the other popular type of mortgage refinance available.