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- The two basic types of mortgage refinances are rate-and-term and cash-out refinances.
- A rate-and-term refinance changes the terms of your old mortgage, while a cash-out refinance also lets you take money out at closing.
- Rate-and-term refinances help you save money on your mortgage, and cash-out refinances give cash to spend on different goals.
When you refinance your mortgage, you're trading your current mortgage for a new mortgage. You may do this for one of two reasons: to change your interest rate or loan term (called a rate-and-term refinance) or to pull from your home equity (a cash-out refinance).
Here's how the two refinancing options compare and when you might choose one over the other:
Defining the differences
Both types of refinances replace your current mortgage loan with a new one, but how they work — and how they'll benefit you — is quite different.
Cash-out refinance: Accessing home equity
With a cash-out refinance, you'll still replace your old mortgage with a new one that has different terms. But you'll actually take out a loan larger than what you have now, so you can receive the surplus in cash.
A cash-out refinance can be a good option if you've built equity in your home. A lender typically won't let you receive more than 80% of your home's value in cash — minus your existing loan balance.
Let's say your home is valued at $200,000, and you have $100,000 left to pay on your initial mortgage. This means you could take $60,000 via a cash-out refinance (200,000 x .80 - 100,000).
Rate-and-term refinance: Changing loan terms
A rate-and-term refinance is probably what you think of when you hear the term "refinance." You replace your initial mortgage with a new one that comes with better terms.
Your refinanced mortgage brings a new interest rate and a different required monthly payment. You'll also probably refinance into a new term length.
Maybe you originally took out a 30-year mortgage at a 6% interest rate. You have 25 years left on your mortgage, but instead of keeping the same loan, you get a 15-year mortgage refinance and a 5% rate. This way, you'll pay off your mortgage sooner and pay less in interest.
You could also opt to get a 30-year mortgage refinance, resetting the clock on your loan and lowering your monthly payment amount with a longer term.
When to consider a cash-out refinance
Your choice between a rate-and-term refinance and a cash-out refinance will come down to your ultimate goal behind refinancing. Do you want new terms so you can pay less, or do you want to pocket cash so you can achieve other financial goals?
If you're wondering "should I do a cash-out refinance" and have any of the below goals, you might want to consider it.
You're consolidating debt
Mortgages come with some of the lowest interest rates around. This makes them great tools for paying off debts.
Here's an example, say you have two $10,000 credit card balances. Each card has today's average card interest rate of about 21%. If you were to use a cash-out refinance to pay those off (essentially rolling them into your mortgage balance), you'd instead pay today's average mortgage rate around 7% — amounting to significantly less interest in the long run.
You're funding home improvements.
Cash-out refinances can give you money to repair your house, renovate, or make other home improvements.
There are no legal limits on how you can spend the money you receive from a cash-out refinance, so using it to add value to your house is a great strategy.
You're funding major expenses (education, medical, etc.)
Because they come with such low interest rates compared to other products, cash-out refinances are also a smart way to cover big expenses like your child's college tuition, unexpected medical bills, and more.
Essentially, if your only option to pay for these things is a high-interest credit card or loan, a cash-out refinance may be your most affordable option.
When to consider a rate-and-term refinance
Unless you need a huge chunk of change to use as you wish, rate-and-term refinance benefits may be better for your long-term finances. Here's when you might want to consider one:
You want to lower your mortgage interest rate
Most people use these refinances to reduce their interest rate. Today, for example, the average interest rate on a 30-year mortgage is about 7% as of last publish time. If rates drop to 5% in two years, you may want to do a rate-and-term refinance to take advantage of those lower rates and reduce your long-term interest costs. It can also help lower your monthly payment and free up cash flow for other needs.
You want to shorten your loan term
If you want to pay off your loan quicker or have gotten a raise and can afford a larger monthly payment, you can also use a rate-and-term refinance to get a new loan with a shorter term. For instance, you could refinance from a 30-year loan to a 15-year one. While this would equate to higher monthly payments, it would save you lots in long-term interest and help you pay off your loan balance faster.
You could also use the opposite strategy to lower your payments, refinancing into a longer-term loan (or another 30-year loan a few years down the line). This could help if you're having financial difficulties or need to free up cash.
You want to switch loan types
Finally, you can also use a rate-and-term refinance to take out a new loan type. This might be something you'd want to do if you have an adjustable-rate mortgage (ARM), for example.
ARMs usually have a low interest rate for the first few years of the loan and then start to increase. If you want to avoid that increase, you may want to refinance into a fixed-rate loan before the adjustment date.
You can also use this strategy if you want to get rid of mortgage insurance. If you have an FHA loan, for instance, you can get rid of pricey monthly mortgage insurance by refinancing into a conventional loan once you have at least 20% equity in your home. This could reduce your monthly payment quite a bit.
Know the downsides
Make sure you consider the pros and cons of cash-out refinances and rate-and-term refinances before pursuing either. Both use your home as collateral and put it at risk of foreclosure if you can't make your payments.
And if you do choose to refinance, shop around for your lender. Mortgage companies vary widely on fees and rates, so comparing your options can help you get the most affordable deal.
FAQs
Any type of new loan can result in a small dip in your credit score. Managing your debt responsibly, though, and making on-time payments — every time — will improve your score in the long run.
Yes, you can technically do a cash-out refinance and lower your rate at the same time, if market rates are lower than the rate on your current loan. Keep in mind, though, cash-out refinances are a little riskier for lenders, so they usually come with slightly higher rates than rate-and-term refinances.
Cash-out refinances require more equity, as you'll need to retain at least a 20% stake in your home — after taking out the new loan. With cash-out refinances, the amount of money you can get from the loan directly correlates to how much equity you have.
Closing costs can be higher on cash-out refinances, often because they have higher loan balances than rate-and-term refinances (and many closing costs are charged as a percentage of the loan balance).
Rate-and-term refinances are often easier to qualify for. Cash-out refinance requirements tend to be stricter, as they are higher-risk. Lenders typically require larger amounts of equity and lower debt-to-income ratios.
A cash-out refinance replaces your old mortgage loan with a new, larger one. You then get the difference between the two balances in cash. A HELOC is a second loan, which lets you take money out of your home equity. It requires a second monthly payment, and you can withdraw from the loan as needed over a period of 10 years.
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