Rate-and-term refinance explained

#What a rate-and-term refinance is

You take out a new mortgage, use it to pay off the old one, and keep the house as security. The new loan covers what you owe plus, if you choose, the closing costs — but not fresh cash. That is the difference from a cash-out refinance, where you borrow more than you owe and take the difference.

People use a rate-and-term refinance to:

• Lower the rate when market rates have fallen or their credit has improved since they borrowed.
• Change the term — from 30 years to 15 or 20 to pay the loan off sooner, or occasionally to a longer term to cut the payment.
• Switch loan type, such as an adjustable-rate loan to a fixed rate before it resets, or an FHA loan to a conventional one to drop mortgage insurance.

FHA and VA borrowers have a lighter-paperwork version for loans of the same type, the streamline refinance.

#The limited cash-out rule on conventional loans

For a conventional loan sold to Fannie Mae, a rate-and-term refinance is called a limited cash-out refinance. Under the Selling Guide, the new loan can pay off the existing first mortgage, finance closing costs, points and prepaid items, and pay off a second mortgage only if that second loan was used to buy the home. Any cash you receive at closing, added together, can’t exceed the greater of 1% of the new loan or $2,000.

In practice the cap depends on the loan size: on a $350,000 refinance it is $3,500; on a $150,000 loan it is $2,000. Pay off a home equity line you used for a kitchen remodel, and the deal becomes a cash-out refinance with tighter limits and usually higher pricing.

At least one borrower must be on title when you apply, and a home that was listed for sale must be taken off the market by the time the new loan funds.

#When it makes sense

A refinance makes sense when the lower payment or interest saving earns back the closing costs well before you expect to move or refinance again. Three questions decide it:

1. How much lower is the new rate? There is no universal rule of thumb; a small drop can pay on a large balance and fail on a small one.
2. What term will you choose? Restarting at 30 years when you have 25 left lowers the payment partly by stretching the debt.
3. How long will you keep the loan? If you may sell within a few years, the costs may never come back. See when not to refinance.

#A worked example

The 30-year loan gives the biggest monthly saving, yet over its full life it costs more interest than the loan you have, because it adds three years of payments. The 25-year option saves less each month, but more of each payment goes to principal, so you are ahead sooner on the full measure. The 15-year loan raises the payment by $431 a month — and pays for itself fastest, because a lower rate and a shorter term both cut interest. Which one fits depends on your budget, not only the math. Our break-even guide explains the two measures.

#Costs, and doing it step by step

Freddie Mac puts refinance costs at 3%–6% of the loan — appraisal, title services, lender and recording fees among them. You can pay them in cash, add them to the loan within the LTV limit, or take a higher rate in exchange for a lender credit; see no-closing-cost refinances and refinance closing costs.

1. 1

   Gather your numbers

   balance, rate, years left and a rough home value, from your latest statement and recent sales nearby.

2. 2

   Apply with several lenders

   within 45 days, so the credit checks count as a single inquiry.

3. 3

   Compare Loan Estimates

   line by line, using the same lock period and points for each. See Loan Estimate and Closing Disclosure.

4. 4

   Lock and complete underwriting

   income documents, the appraisal if required, and title work.

5. 5

   Close and wait out the right to cancel.

   With a new lender you have 3 business days to change your mind before the old loan is paid off.