What is a rate and term refinance?
A rate and term refinance is a type of mortgage refinance that meets certain criteria. As the name suggests, your interest rate and term -- which is the length of your loan -- can change when you refinance but there are limits to other aspects of the loan, especially your mortgage amount and how the proceeds are used.
In most cases, with a rate and term refinance -- also known as a limited cash-out refinance -- your loan amount remains the same (or similar) but your mortgage rate usually decreases. A good example is if you have a 30 year fixed rate mortgage with a 4.250% rate and a $225,000 principal loan balance and you refinance into a new $225,000 30 year mortgage with a 3.500% rate. In this case, the only part of the loan that changed is the mortgage rate.
Use ourMORTGAGE REFINANCE CALCULATORto determine how much you can save by refinancing
You may also decide to change your loan term or program. For example, you could refinance a 30 year mortgage into a 15 year loan or switch from an adjustable rate mortgage (ARM) into a fixed rate loan, or vice versa.
The most important requirements for a rate and term refinance focus on how the loan is used. Specifically, the refinance proceeds can only be used for the following purposes:
Pay off your existing first mortgage balance
Pay off a second mortgage -- also known as a piggyback loan or second trust deed -- that was only used to purchase the property. You cannot use the refinance proceeds to pay off a home equity loan or line of credit that was used for property renovations or other purposes
Pay for closing costs including discount points and prepaid expenses such as homeowners insurance and property taxes (as long as you meet certain guidelines)
Pay off a PACE loan or similar energy efficiency loan
For a standard conventional refinance, the borrower can take cash out up to a maximum of $2,000 or 2.0% of the new mortgage amount, whatever is lower. Please note that the borrower is not required to receive any proceeds from the loan. Some refinance assistance programs permit the borrower to receive a lower amount of proceeds
Pay for prepayment penalties on the existing mortgage
Buy out another person’s ownership interest in the property
The example below demonstrates the maximum mortgage amount permitted with a standard rate and term refinance. This example assumes the property has no second mortgage, PACE loan or other liens aside from the first mortgage.
Current Mortgage Balance: $225,000
Closing Costs: $4,000
Prepaid Items: $3,000 (homeowners insurance and property tax)
Discount Points: $2,250 (assumes one point)
Maximum Cash to Borrower: $2,000 (lower of $2,000 or 2.0% of new loan amount)
Maximum Rate and Term Refinance Loan Amount: $236,250
As illustrated by this example, there is a limit to the loan amount as well as how you spend the funds.
In addition to restrictions on how you spend the loan proceeds, there are other conditions that must be met to be eligible for a rate and term refinance, which we outline below:
There must be an existing mortgage on the property (except for construction-to-permanent loans). If the property is owned free and clear, you cannot qualify for a rate and term refinance
The mortgage proceeds cannot be used to pay off any liens or loans that were not used to purchase the property (except for PACE and similar loans)
You cannot include back property taxes in the loan amount that are more than 60 days past dueÂ
The property being financed cannot be for sale
If your mortgage meets the guidelines outlined above, it is categorized as a rate and term refinance. If not -- for example if you want to take out more proceeds or pay off a home equity loan -- then the loan is categorized as a cash-out refinance.
This is an important distinction because the loan terms for a rate and term refinance are more favorable than for a cash-out refinance. For example, the mortgage rate for a rate and term refinance is typically .500% to .750% lower, which reduces your monthly payment and saves you money.
The table below shows refinance terms for leading lenders in your area. We recommend that you contact multiple lenders to confirm the type of refinance you need. Shopping lenders also enables you to find the lowest rate and fees.
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The qualification requirements are also different. For example, the maximum loan-to-value (LTV) ratio for a rate and term refinance of a single unit property such as a home, condominium or co-op is 97% as compared to 80% for a cash-out refinance. The higher the LTV ratio, the less equity you need to have in your home to qualify for the refinance.
Additionally, most low down payment and refinance assistance programs only permit rate and term refinances and significantly limit the proceeds you can receive.
In closing, if you want to qualify for the best mortgage terms and expand the programs available to you, then a rate and term refinance is your best option. If you want to receive more proceeds from the loan or have more flexibility on how you spend the funds, then a cash-out refinance is the better alternative. The program that is right for you depends on your personal situation and financing goals.
Sources
"B2-1.3-02, Limited Cash-Out Refinance Transactions." Selling Guide: Fannie Mae Single Family. Fannie Mae, August 7 2019. Web.
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