In the mortgage world, a “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. The existing mortgage is effectively paid off by the opening of the new refinance loan, with the old 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
- Which results in a cheaper monthly payment and interest savings over the loan term
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, it would be a good opportunity to do so to lower their monthly mortgage payment significantly.
On a $300,000 loan amount, the monthly loan 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.
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 payment, get rid of mortgage insurance, or simply to switch loan types.
Read more: How does 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 rate/term without affecting your 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.
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 fixed-rate 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 into refinancing their mortgage to avoid the impact of the fully indexed rate, assuming it’s higher than the initial rate.
These types of loans are rarely held to maturity (or even close to it) because most homeowners don’t want 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.
Look at 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%
Most short-term ARMs are hybrids with 30-year terms. In the above scenario, the interest rate is fixed during the first three years and adjustable during the remaining 27 years.
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.
Instead of getting stuck with a higher rate, the borrower can obtain new home loan financing that is lower than the fully-indexed rate.
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 period comes to an end
- To avoid a much higher interest rate
If the borrower doesn’t refinance after three years, their interest rate will jump from 2.875% to 4.25%, 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 in a rising rate environment.
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 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.
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.
Consider Closing Costs Associated with a Mortgage Refinance
- Aside from the new rate and term
- One should also consider the costs involved
- Which can be quite sizable
- And actually make the decision 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 choose to refinance into a lower fixed-rate mortgage, 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. If they only keep it for a year or two, those costs may never be recouped.
However, it might also be possible 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 – to obtain a lower rate and payment than 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 do the math and look ahead before agreeing to carry out a refinance.
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 a lower payment)
- 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
- To shorten the 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 (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.