Refinancing a mortgage means replacing your existing mortgage with a new loan. You can use a refinance to turn some of your home equity into cash, but it’s also possible to hold onto your home equity and merely swap out your mortgage for a new loan with different features. That’s known as a rate and term refinance.
[Read: Best Mortgage Refinance Lenders.]
What Are the Main Types of Refinances?
A refinance may fall into one of these categories, depending on how much cash you want to take out.
Rate and Term Refinance
A rate and term refinance is sometimes called a “no-cash-out mortgage.” It replaces an existing home loan with a new loan. Homeowners might choose a rate and term refinance to get a better interest rate, switch from an adjustable to a fixed rate (or vice versa), change the repayment term, add features like interest-only payments or release a co-borrower or cosigner from the old loan.
Borrowers who get a rate and term refinance often aim to meet goals such as reducing their monthly payment or paying off the loan faster. Borrowers can also use a rate and term refinance to replace a primary mortgage and second mortgage with one loan. However, the second mortgage proceeds must have been used only to purchase the property or make energy-related improvements.
“They can do it for a variant of reasons, but they don’t really want cash out. They’re doing it more to reset the terms on the loan,” says Diane Mastay, mortgage director at Tropical Financial Credit Union.
A rate and term refinance is used to pay off the current loan, including late fees or prepayment penalties that the borrower might have incurred. The borrower may also be allowed to cover closing costs including discount points with the proceeds, so the refinance may not require an out-of-pocket payment at closing.
Limited Cash-Out Refinance
If you want to tap into home equity to fund a small purchase or pay a few bills, you might choose a limited cash-out refinance. Limited cash-out refinancing doesn’t subject you to the surcharges and stricter underwriting that comes with a cash-out refinance.
A limited cash-out refinance is similar to a rate and term refinance in that the loan proceeds pay off the existing loan(s), including any prepayment penalties and late fees. And the refinance can cover closing costs and discount points.
You also get to take some cash out, but as the name suggests, the amount is limited. A limited cash-out refinance from Freddie Mac allows you to take out cash up to $2,000 or 1% of the new loan amount, whichever is greater. Fannie Mae limited cash-out refinances offer the option of taking out $2,000 or 2% of the loan amount, whichever is less. If maximizing your cash with a limited cash-out refinance is important to you, choose a Freddie Mac loan.
Cash-Out Refinance
Taking equity out of the home to cover home upgrades and repairs, make large purchases or consolidate debts requires a cash-out refinance.
Getting a cash-out refinance means taking out a new loan that’s larger than the remaining balance on your old one. The refinance pays off the existing mortgage and covers closing costs, and you receive the rest of the proceeds in cash. To qualify, you need to have gained enough equity to draw down for the cash. And you’ll typically pay higher loan fees than you would with a rate and term refinance.
It’s important to understand that the extra charges for a cash-out refinance apply to the entire loan, not just the cash you take out. If you want to refinance your mortgage to get better terms and also get some cash, compare the cost of a rate and term loan plus a home equity loan to that of a cash-out refinance before deciding. If your loan balance is large and you only want a little cash, the home equity loan or line of credit, combined with a rate and term refinance, will often be a better deal.
For example, suppose that you owe $500,000 and just want $20,000 in cash. If the surcharge for cash-out is two points, that’s $10,400 — more than 50% of your cash.
[2025 Mortgage Rate Forecast: When Will Rates Go Down?]
How Do You Get a Rate and Term Refinance?
When seeking any home loan, you should shop for the right lender and loan. Compare estimates from different mortgage companies, brokerages, banks or credit unions to find an affordable option that’s in line with your goals.
When you apply, you’ll typically be asked for W-2s from the last two years and recent pay stubs. If you’re self-employed or get rental or significant investment income, expect to provide two years of tax returns. You’ll also submit a copy of your homeowners insurance policy.
You’ll need to show statements from bank, retirement and investment accounts, even if you are having closing costs rolled into the loan. “Reserves,” which are funds that could be used to pay your mortgage if you lose income, can improve your chances of loan approval and are required for some programs.
“Some programs might require two months’ reserves; some programs could go up to six months. They want to make sure that the consumer, once they close, they have the reserves in their bank account,” says Mike Brennan, president at Nationwide Mortgage Bankers.
The lender will also check your credit and order an appraisal.
Streamline Refinances
If you have a Federal Housing Administration, Veterans Affairs or U.S. Department of Agriculture loan, the refinancing process can be a bit easier if you get a streamline refinance. Streamline refinances are simplified rate and term refinances that replace your current mortgage with a new home loan from the same program.
— FHA streamline refinance. This refinance doesn’t require an appraisal. You can opt not to share income and credit information with the lender, but you’ll pay a slightly higher interest rate. If you’re removing a borrower from the loan, you must complete a more in-depth application that documents your income and credit.
— VA interest rate reduction refinance loan. An IRRRL must feature a lower interest rate than the original loan, unless you’re replacing an adjustable-rate mortgage with a fixed-rate mortgage. You usually don’t need an appraisal or credit check, although you might have to show proof of on-time payments or make a statement that you can afford the loan if you’re removing a borrower.
— USDA streamlined refinance. This is an option if your original loan is a USDA guaranteed loan or a direct loan that never received a subsidy. You don’t need a new appraisal, but you must provide documentation of your income and credit. You can add or remove a borrower.
— USDA streamlined-assist refinance. Both guaranteed and direct USDA loans may be refinanced through this option. You generally don’t have to get a new appraisal, but you must meet income limits and have no defaults on your credit in the last 180 days. You can add a borrower but can’t remove a borrower unless they’ve died.
Pros and Cons of a Rate and Term Refi
Before choosing a rate and term refinance, consider which of these pros and cons apply to your situation.
Pros
Lower interest rate.
If you’ve boosted your credit score since taking out your current mortgage, or if you bought your house at a time when interest rates were higher, refinancing can give you a lower interest rate.
Lower payment.
A rate and term refinance can make your mortgage payment more affordable, either by lowering your interest rate or by spreading payments out over a longer term.
Faster payoff.
Switching to a loan with a shorter term puts you on track to own your home outright sooner. And because you’re not taking cash out, the refinance doesn’t reduce the equity you’ve already built up in your home.
Avoid interest rate adjustments.
If you have an adjustable-rate mortgage and you expect interest rate increases in the future, refinancing to a fixed-rate mortgage could help you steer clear of big jumps in your monthly payment.
Remove mortgage insurance.
If you have an FHA loan, you typically have to pay a mortgage insurance premium for the entire life of the loan. Refinancing to a home loan that doesn’t require mortgage insurance could save you money.
“Once you start paying down your principal balance and say you get down to 20% equity, there’s a really good chance it makes sense for you to refinance into a conventional,” Brennan says.
You may also be able to cancel conventional loan mortgage insurance by refinancing if your property value has increased. Maybe you bought two years ago and your loan-to-value was 90%. If it would be under 80% today, you can drop mortgage insurance. But even if your new loan would be an 85% loan-to-value, your new mortgage insurance would be cheaper. You can also save if your credit score has increased since you bought your home.
[READ: Today’s FHA Mortgage Rates]
Cons
Closing costs breakeven.
Closing costs on a refinance generally add up to 3% to 6% of the loan amount, according to Freddie Mac. The savings from a reduced interest rate accrue as you make payments over time, so it can take years to break even on a refinance. Thus, it usually doesn’t pay to refinance if there’s a good chance you’ll move soon. If you are, look for a loan with low or no closing costs.
“You don’t want to pay a lot of closing costs if you don’t plan to be in the house. And so it’s always good to consider that if you’re going to be in the house for the next five years,” Mastay says.
Resets amortization schedule.
An amortization schedule shows how the portions of your monthly mortgage payment going to principal and interest change over time. When you’ve been paying off your mortgage for several years, a larger share of each payment goes to reducing the principal.
Refinancing brings you back to the start of the amortization schedule, so that a larger fraction of each payment goes to interest and a smaller part goes to building equity.
Can increase total interest cost.
If you refinance to a mortgage with a longer term or the same term as your current home loan, you pay interest over a longer time. The total amount of interest you pay might end up being higher than if you hadn’t refinanced, even if you get a lower interest rate.
Brennan gives the example of a borrower who has 25 years left on the mortgage and refinances to a 30-year loan with a lower interest rate. “That might be seen as a positive, but if I go back into a 30-year mortgage, I would be adding years back onto my mortgage. So yes, I’m saving $150 a month, but I just added almost 60 payments back to my mortgage,” Brennan says.
More from U.S. News
I Got a Tax Windfall: Should I Recast My Mortgage or Make a Principal Payment?
2025 Mortgage Rate Forecast: When Will Rates Go Down?
Mortgages Under Trump: What Happens if He Privatizes Fannie Mae and Freddie Mac?
What Is a Rate and Term Refinance? originally appeared on usnews.com
