Rate and Term Refinance

In the mortgage realm, a “refinance” refers to the replacement of an existing mortgage(s) with a new home loan. The refinance loan will come with a new interest rate (ideally lower) and mortgage term. The existing mortgage is effectively paid off by the opening of the new refinance loan, with the old balance being transferred to the new loan.

Think of it this way – you are re-financing your mortgage, meaning you are obtaining new financing for an existing loan.  The issuer of the new mortgage pays off the old loan with the proceeds from the new loan.

When you obtain new financing, you can either go back to your original mortgage lender or shop around with other banks and lenders.  Either way, when you refinance you are seeking out new financing terms for one reason or another.

Tip: How does refinancing work?

What type of refinance are you looking for?

The simplest type of mortgage refinance is called a “rate and term refinance” because the borrower is simply 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.

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 loan.

An example would be a 3-year ARM. The first three years are fixed, and then the mortgage becomes adjustable, based on the margin and index tied to the loan. At or before this first adjustment, borrowers will often look to refinance to avoid the impact of the fully indexed rate, assuming it’s higher than the initial rate.

[When to refinance a home mortgage.]

Look at this example of a rate and term refinance in action:

Loan type: 3-year ARM
Loan amount: $500,000
Start rate: 5.875%
Margin: 2.25
Index: 5.439%
Fully indexed rate: 7.69%

Most short-term ARMs are hybrids with 30-year terms. In the above scenario, the first three years are fixed and the remaining 27 years are adjustable. This may be represented as a 3/1 ARM.  After three years, the interest rate adjusts to the sum of the margin and index, and can adjust annually both up or down.

Your Mortgage Rate May Rise If You Don’t Refinance

If the borrower doesn’t refinance after three years, their interest rate will jump from 5.875% to 7.69%, using our example from above. 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.

So most borrowers will likely look to refinance their existing loan with a new loan with a longer fixed period and a lower interest rate. Or simply refinance into another ARM with an initial teaser rate.

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, or broker.

It is always recommended that you shop around when looking to refinance, as rates, closing costs, underwriting requirements, and loan programs can and will vary greatly from lender to lender.

Consider Closing Costs Associated with a Refinance

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 are offset by lower monthly mortgage payments, so subsequent payments save the homeowner money each month.

Think of it this way. If the homeowner stays in their adjustable-rate mortgage at 7.689%, they will pay $3561.01 a month in principal and interest payments. If they choose to refinance into a lower fixed-rate mortgage, say 6.5%, they’ll pay $3160.34 a month in principal and interest payments. That’s a savings of $400.67 a month.

Sure, there may be closing costs associated with a refinance, but the monthly savings will cover those costs over time. Additionally, you might even be able to execute a no cost refinance whereby you pay no closing costs in exchange for a slightly higher-than-market rate, but still receive a rate well below your existing one.

These monthly savings are exactly why a homeowner would opt to carry out a rate and term refinance.  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 do the math and look ahead before agreeing to carry out a refinance.

[The refinance rule of thumb.]

Why Homeowners Refinance Their Mortgages

  • To obtain a lower mortgage rate
  • 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 debt
  • To pay off high-interest rate credit cards and other loans
  • To remove someone from a loan (ex-spouse)
  • To remove mortgage insurance
  • To switch loan programs, such as FHA to conventional

Tip: Most mortgage lenders will let a borrower take out incidental cash-out (home equity) 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.


15 Comments

  1. sam March 2, 2013 at 10:12 am -

    dealing with 2 lenders one is offer 25yrs 3.99% and other 30yrs 3.75%. which is better over all.

  2. Colin Robertson March 2, 2013 at 11:31 am -

    Sam, a shorter term fixed mortgage should have a lower rate. For example, 15-year fixed mortgages should always price lower than 30-year mortgages.

    So in your scenario, the 25-year loan should be priced lower than the 30-year.

    However, shorter term fixed loans can result in you paying less interest, meaning the 25-year loan could save you money over the entire term of the loan.

    But when rate shopping, you should find that shorter term loans come with lower rates.

  3. Trevor July 13, 2013 at 3:42 pm -

    Thinking about doing a rate/term refi on my current mortgage. I got it back in 2003 at a rate of 5.25%. It’s a 30-year fixed. I’ve been offered a rate of 4.5%. Is that a good deal?

  4. Colin Robertson July 14, 2013 at 2:39 pm -

    Seeing that you’ve held the loan for a decade, you’ve already paid quite a bit of interest. And if you refinance to another 30-year loan, you’ll pay a lot more interest, assuming you hold the loan to term. With the two rates being not all that far off, a better idea might be to look at a shorter-term loan, such as a 15-year fixed. You’ll get a lower interest rate too. But if you plan to move anytime soon, as opposed to paying off the loan, you might not want to invest more into your home. Use some calculators to see the actual math before making a decision either way.

  5. Jerrod July 29, 2013 at 11:02 am -

    A rate and term loan only makes sense if interest rates are significantly lower than your current interest rate. There was a good window of opportunity there for a few years, but it seems to be over for most people today, unless your rate is above 6% or so.

  6. Tom August 14, 2013 at 10:51 pm -

    Another good reason to do a rate and term refi is to reduce the loan term. e.g. Going from a 30-year loan to a 15-year loan to save a ton of money on interest, especially if the new rate is low enough to offset the increase in payment.

  7. Florence August 25, 2013 at 6:34 pm -

    My current rate is 5.25% on a 30-year loan. I’ve had it since 2010. Should I refinance to another 30-year fixed at 4.625% or go with an ARM instead?

  8. Colin Robertson August 26, 2013 at 2:11 pm -

    It depends on how much cheaper the ARM is, how long it’s fixed for (5/7/10 years), and if you’re okay with it adjusting higher. Fixed loans come with peace of mind, while ARMs give you immediate payment relief. Depends what you’re looking for and what your goal with the property is.

  9. Zuma September 14, 2013 at 8:14 pm -

    Don’t refinance to an ARM unless you know you’ll be out by the time it becomes adjustable. Rates are only going higher!

  10. Joe January 18, 2014 at 5:20 am -

    Are rate and term refinances cheaper if you don’t take any cash out?

  11. Colin Robertson January 20, 2014 at 9:22 pm -

    Generally, yes, the mortgage rate will be lower for a rate and term refi. Additionally, you’ll typically have added flexibility, such as a higher LTV allowance, and/or a lower credit score requirement.

  12. Aurelio February 18, 2014 at 12:55 pm -

    Can you do a rate and term refinance with no seasoning? I recently purchased a home and want to switch loan programs.

  13. Colin Robertson February 19, 2014 at 5:51 pm -

    Some lenders may make you wait 120 days, or 4 months, before getting a rate and term refinance, but others have no seasoning requirement. Shop around.

  14. Cheryl June 10, 2014 at 11:18 am -

    If I am paying off a home equity line of credit on a home i paid cash for originally, am I able to apply for a rate and term refinance? My loan officer told me it would be considered taking cash out.

  15. Colin Robertson June 10, 2014 at 1:30 pm -

    Cheryl,

    If the home equity line wasn’t a purchase-money HELOC, that is, used to buy your home, lenders consider it cash out when you refinance if it’s a subordinate mortgage. If it’s in the first-lien position it may be eligible as rate and term.

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