Refinance guide rate-and-term refinance vs cash-out
Rate-and-Term Refinance vs Cash-Out Refinance: Which Is Right for You?
Refinancing a mortgage can be a powerful financial move when done for the right reasons. Two common refinance options are the rate-and-term refinance and the cash-out refinance. Though they both replace your current mortgage with a new one, they serve different goals and carry different costs and risks. This guide explains each option, when it makes sense, the benefits and drawbacks, typical fees, the step-by-step process, common pitfalls to avoid, and a short FAQ to help you decide.
What Each Option Is and When It Makes Sense
Rate-and-Term Refinance
A rate-and-term refinance replaces your existing mortgage with a new loan to change the interest rate, the loan term (for example from 30 years to 15 years), or both—without taking out additional cash beyond possibly rolling closing costs into the loan. Homeowners use this option to reduce monthly payments, lower interest costs over time, move from an adjustable-rate mortgage (ARM) to a fixed-rate loan (or vice versa), or shorten the payoff period.
Cash-Out Refinance
A cash-out refinance replaces your current mortgage with a larger loan and gives you the difference in cash at closing. You convert a portion of your home equity into cash, which can be used for home improvements, debt consolidation, major expenses, or investment. This is appropriate when you need significant cash and have enough home equity to support a larger loan balance.
Benefits and Drawbacks
Rate-and-Term Refinance
- Benefits:
- Lowers monthly payments or shortens loan term.
- Can secure a lower interest rate and reduce total interest paid.
- May eliminate an ARM reset risk by switching to a fixed rate.
- Can remove or add borrowers (subject to lender rules).
- Drawbacks:
- Closing costs can offset savings if you sell or refinance again soon.
- May extend the repayment period if you reset to a longer term.
Cash-Out Refinance
- Benefits:
- Access a relatively low-cost source of cash compared with unsecured loans or credit cards.
- Use funds for renovations that increase home value, debt consolidation, education, or other needs.
- May allow you to consolidate higher-interest debt into a lower-rate mortgage.
- Drawbacks:
- You increase your mortgage balance and potentially your monthly payment.
- Interest rate on cash-out refinances is often higher than a straight rate-and-term refinance.
- Using cash for non-investment purposes can put your home at greater financial risk.
Costs and Fees
Both refis involve closing costs similar to those for a purchase. Expect typical total fees of roughly 2% to 6% of the loan amount, though this varies by lender, loan size, and local costs. Common fees include:
- Loan origination fee (commonly 0.5%–1.5% of loan)
- Appraisal fee ($300–$700 typical)
- Title search and title insurance
- Underwriting and processing fees
- Recording fees, escrow, and prepaid interest
- Points (optional; can buy down rate)
- Private mortgage insurance (PMI) if your LTV exceeds the lender’s threshold
Note: cash-out refinances often have slightly higher rates and sometimes higher loan-to-value (LTV) restrictions than rate-and-term refinances. Tax rules: mortgage interest tax deductions may vary—interest on cash used to substantially improve your home is typically deductible, but consult a tax advisor for specifics.
Step-by-Step Refinance Process
- Assess your goal: lower rate, shorten term, access cash, or remove PMI.
- Check your credit score and debt-to-income ratio; improve them if possible.
- Estimate savings and break-even point: divide total closing costs by monthly savings to get months to recoup costs.
- Shop lenders for rate quotes and compare APR, fees, and loan features.
- Submit an application with documentation (income, assets, tax returns, current mortgage statements).
- Lock your interest rate if the terms are favorable.
- Undergo appraisal and underwriting; respond quickly to information requests.
- Review closing disclosure, attend closing, and sign. For cash-out, receive cash at closing.
- Confirm old loan payoff and new payment schedule; set up payments and escrow as needed.
Common Pitfalls to Avoid
- Failing to calculate the break-even. If you plan to move or sell within the break-even period, refinancing may not make sense.
- Rolling all closing costs into the loan without considering the extra interest paid over time.
- Using a cash-out refinance to fund lifestyle spending that won’t improve your finances or home value.
- Underestimating the impact of a longer loan term—lower payments might mean paying more interest over the life of the loan.
- Not shopping multiple lenders—small rate and fee differences can change the math significantly.
- Ignoring PMI rules—cash-out may push your LTV above the PMI threshold, costing you more.
Short FAQ
Q: What’s the main difference between a rate-and-term and a cash-out refinance?
A rate-and-term refinance changes your interest rate and/or term without increasing your loan balance for cash. A cash-out refinance increases your mortgage balance so you can receive cash at closing.
Q: How long does it take to recoup refinancing costs?
Use the break-even formula: closing costs divided by monthly savings = months to recoup. If closing costs are $4,000 and monthly savings are $200, break-even is 20 months. If you plan to sell before that, refinancing may not pay off.
Q: Will refinancing affect my credit?
Yes. The application results in a hard credit inquiry and a new account. You may see a small, temporary dip in score, then potential improvement if the refinance lowers your payment and you make on-time payments.
Q: Can I do a cash-out refinance if my credit is poor?
It’s harder. Cash-out loans are typically underwritten more strictly—lenders want strong credit, stable income, and sufficient equity. Improving credit or waiting to build equity may yield better terms.
Choosing between a rate-and-term refinance and a cash-out refinance depends on your financial goals, how long you’ll stay in the home, and your tolerance for increasing your mortgage balance. Run the numbers, shop lenders, and consider consulting a financial or tax advisor before moving forward.
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