Rate and Term Refinance
A “mortgage refinance” refers to the replacement of an existing mortgage(s) with a new home loan with a new interest rate and set of terms. The existing loan is effectively paid off by the opening of the new loan, with the old balance being transferred to the new loan.
This type of refinance is called a “rate and term refinance” because the borrower is simply changing the rate and terms of the loan, and not the balance (how does refinancing work?).
Usually 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. 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 look to refinance to avoid the impact of the fully indexed rate, assuming it’s higher than the initial rate.
Look at this example:
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. In the above scenario, the first three years are fixed and the remaining 27 years are adjustable. This may be represented as a 3/27 ARM. After three years, the rate adjusts to the sum of the margin and index, and can adjust every six months or annually depending on program specifics.
If the borrower doesn’t refinance after three years, their interest rate will rise from 5.875% to 7.69% using our example 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 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. The borrower will usually have the choice of refinancing their existing loan with their current lender or searching for different loan programs with a new lender. Although there will be closing costs associated with the new mortgage, the associated lower rate and improved terms will eventually offset these costs and benefit the borrower in the long run.
Think of it this way using our example above. If a homeowner stays in their adjustable-rate mortgage at 7.689%, they will be paying $3561.01 a month in principal and interest payments. If they choose to refinance into a lower rate at say 6.5%, they’ll be paying $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 savings will cover those costs quickly.
There are a number of reasons homeowners choose to refinance their mortgage that include:
• More favorable rates and terms
• Extended fixed-rate periods
• Lower monthly mortgage payments
• Tax deductions
• Consolidating debt
• Paying-off high-interest rate credit cards and loans
Also note that most mortgage lenders will also let a borrower take out incidental cash-out of the lesser of 2% of the loan amount or $2,000 – $5,000. Anything beyond that would be considered a cash-out refinance.
