Mastering Rate-and-Term Refinance: A Complete Explainer

Buying a home is a long-term investment, but that doesn't mean you have to be stuck with the same mortgage the entire time.

As mortgage rates fluctuate or your life circumstances change, you might consider refinancing to change some of the details of your loan. To do this, you'll need to get a rate-and-term refinance.

What is a rate-and-term refinance?

With a rate-and-term refinance, you replace your current mortgage with a new one with different terms. You'll get a new interest rate and potentially a new term length, hence the name "rate-and-term."

Your monthly mortgage payment amount will also change because a) you're paying a different amount toward interest each month, and b) refinancing into a longer or shorter term will affect how much you pay monthly. Multiple types of mortgages offer rate-and-term refinances, including conventional, FHA, VA, and USDA loans.

You may sometimes hear a rate-and-term refinance referred to as a "no-cash-out refinance," as you can't use these to turn your home equity into cash. That would require a cash-out refinance instead.

Benefits of a rate-and-term refinance 

Refinances can often be a smart move — if done at the right time. Here are just a few of the benefits of rate-and-term refinancing. 

Potential for lower interest rates

A lower interest rate is potentially the biggest benefit of a rate-and-term refinance. If mortgage rates have gone down since you first took out your loan, refinancing could allow you to get a lower interest rate. 

This would mean less interest paid each month (i.e., a lower payment), and it could save you thousands over the life of your loan.

Opportunity to change the loan term

Rate-and-term refinances also let you choose a different term for your new loan. So, instead of a 30-year mortgage term, you could refinance into a 15-year mortgage. This would allow you to pay off your loan balance sooner and with significantly less interest.

If you refinance into a shorter term, you'll also own your home outright sooner. Just be prepared to potentially pay more each month to do it.

Possible monthly payment reduction

Since rate-and-term refinances can give you a lower interest rate, they could result in a lower monthly payment, too. Additionally, if you refinance into a longer term, your payments will drop even more significantly. (Although it would then take you longer to pay off your home.)

You also may be able to remove private mortgage insurance from your payments by refinancing. This only happens if you have at least 20% equity in your home — meaning your total mortgage balance is 80% or less of your home's value. 

Rate-and-term refinance guidelines

Qualifying for a rate-and-term refinance isn't always easy. You'll need a decent credit score, equity in your home, and to meet other certain criteria.

Eligibility criteria

The exact criteria you'll need to meet will depend on the lender and loan program you choose, but generally speaking, here are the requirements you can expect: 

• Home equity. You'll typically need at least a little bit of equity in your home to refinance. For conventional loans, the max loan-to-value ratio is 97%, meaning you'll need at least 3% equity to qualify
• Credit score. The minimum credit score will depend on which type of mortgage you are refinancing. A conventional mortgage requires at least a 620 score; FHA loans allow scores down to 500 in some cases.
• Debt-to-income ratio. The DTI ratio you'll need also depends on which type of mortgage you have. Typically, it can't be higher than 50%.

Required documentation 

The documents you'll need for a rate-and-term refinance are the same ones you needed when initially applying for your mortgage.

You will need:

• Income documentation, including W-2s, 1099s, pay stubs, and Social Security statements
• Tax returns from the last two years
• Copy of your driver's license or other identification
• Bank statements for the last two months
• Proof of your homeowners insurance policy
• Statements for savings or investment accounts

Your lender may require other documentation, too. Ask your loan officer about what documents you should prepare before you file your application.

When to consider a rate-and-term refinance

Rate-and-term refinances can be beneficial, but they're not right for every homeowner. These considerations can help you determine when to refinance your mortgage. 

Market conditions favoring refinancing

Market conditions play a big role in whether a rate-and-term refinance makes sense. Since you're replacing your current loan with a new one — and more importantly, a new interest rate — being aware of market interest rates is critical before choosing to refinance.

First, know what the rate on your current mortgage is, and then check out Business Insider's daily mortgage rate coverage to see how rates are trending.

If current rates are lower than the rate on your existing mortgage — ideally by at least half a percentage point — then refinancing may make sense financially. 

Changes in financial situation

Your financial situation should factor in, too. If your income has dropped, for example, refinancing into a longer-term loan can help you reduce your monthly payment. 

If, on the other hand, you got a raise and can now afford a larger payment, you may want to do the opposite — refinancing into a shorter-term loan to pay off your balance quicker. This would also reduce your long-term interest costs.

Goals for refinancing

Having a clear picture of your mortgage goals will help you make the right choice for your household. Do you want to pay off your mortgage as quickly as possible and with the least interest? Or is minimizing your monthly payment and stretching your budget most important?

You can also factor in other financial goals. If you want to free up cash for other investments, for instance, refinancing may be able to help you do that.

Process of a rate-and-term refinance

The rate-and-term refinance process isn't very different from getting an initial mortgage. You'll choose a mortgage lender, apply for your loan, and then close on the loan and pay your closing costs. Here's how the exact process breaks down.

Steps to apply for refinancing

To apply for a refinance, you'll need to first determine which loan program you want to use. There are conventional loans, as well as government-backed options like FHA, USDA, and VA loans. If you're not sure which is right for your budget and credit score, talk to a loan officer.

After that, you should:

• Gather your documents. You'll need these when filling out your applications.
• Choose which lenders you may want to work with. Consider a mix of banks, credit unions, and online lenders.
• Apply for preapproval. Lenders will then give you a loan estimate you can use to compare offers.
• Fill out the full application. Complete your chosen lender's application and submit all required documentation.
• Get your home appraised. The lender will send out an appraiser to determine the value of your home.
• Lock your interest rate. This protects you from rate increases before you close on your loan. Work with your loan officer to determine the best time to lock.
• Close on your loan. This is when you'll sign the final documents and pay your closing costs.

Choosing the right lender

As with any mortgage, picking the right lender is critical. Not only will it impact what loan programs you have access to, but it can influence your rate and fees heavily, too. 

Always get quotes from at least a few different mortgage lenders. Then, use the loan estimates they give you to compare rates, fees, and other details. You can also negotiate with lenders using these forms.

Closing on the new mortgage

Finally, you'll close on your new loan. Once you're done, the new loan will be used to pay off the old one, officially replacing it. You'll start making payments on the new mortgage the following month.

Keep in mind that refinances require closing costs just like traditional mortgages. You can typically expect to pay anywhere from 2% to 5% of the mortgage amount. Some lenders will let you finance these costs — meaning include them in your loan balance — but this results in a higher payment and more interest costs in the long run.

Rate-and-term refinance considerations and drawbacks

Rate-and-term refinances can sometimes be a smart move, but they aren't perfect. Here's what you'll want to consider before moving forward with one. 

Closing costs and fees

Closing costs are one of the biggest drawbacks of rate-and-term refinancing. While you may be able to roll these into your loan balance, that will cost you more in interest in the long run.

Break-even point analysis

Calculating your break-even point can help you determine if a rate-and-term refinance is financially worth it. Just take the total closing costs for your refinance and divide them by the monthly savings the refinance would offer you. This gives you the break-even point — the month in which the refinance saves you more than it cost to take out. If you know you'll stay in the home long enough to reach that month, refinancing may be smart.

Impact on total interest paid over the life of the loan

You should also think about the lifetime savings a refinance could net you — particularly if you plan to stay in the home for the long haul. 

Once you've received a few quotes, use a mortgage calculator to determine how much the refinance could save you over the full term of your loan. Sometimes, even a small drop in your interest rate can equate to tens or even hundreds of thousands saved.

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