Refinance guide rate-and-term refinance vs cash-out

Rate-and-Term Refinance vs. Cash-Out Refinance: Which One Is Right for Your Home?

Refinancing your mortgage can be a powerful tool to save money, reduce monthly payments, shorten your loan term, or tap home equity for cash. Two common types are the rate-and-term refinance and the cash-out refinance. Understanding how each works, their costs, and when they make sense will help you choose the right path for your financial goals.

What Each Refinance Is — and When It Makes Sense

Rate-and-term refinance replaces your existing mortgage with a new loan that changes the interest rate and/or the loan term but does not increase the balance to take money out. Typical reasons to do this:

• Lower the interest rate to reduce monthly payments or total interest paid.
• Shorten the loan term (e.g., move from a 30-year to a 15-year mortgage) to pay off the loan faster.
• Change loan type (adjustable-rate to fixed-rate or vice versa) to reduce interest-rate risk.

Cash-out refinance replaces your current mortgage with a larger loan and gives you the difference in cash. Typical uses:

• Home improvements that increase property value.
• Debt consolidation when you can replace high-interest debt with lower-rate mortgage debt.
• Large expenses like education, business investment, or emergency reserves.

Benefits and Drawbacks

Rate-and-Term Refinance — Benefits

• Lower interest rate and monthly payment if rates have fallen or your credit improved.
• Potentially large savings in total interest if you shorten the term.
• No increase in mortgage balance, so less chance of overleveraging your home.

Rate-and-Term Refinance — Drawbacks

• Closing costs can offset savings if you don’t keep the loan long enough (breakeven point).
• Extending the term can reduce payments but increase total interest paid over the life of the loan.

Cash-Out Refinance — Benefits

• Provides a lump-sum of cash—often at a lower interest rate than credit cards or personal loans.
• Can be used to invest in value-adding home improvements or to consolidate higher-interest debts.
• Simplifies payments by rolling other debts into the mortgage if that makes sense.

Cash-Out Refinance — Drawbacks

• Higher loan balance and potentially higher monthly payments.
• Often more stringent qualification criteria and higher interest rates than rate-and-term refis.
• May require mortgage insurance or have lower maximum loan-to-value (LTV) limits.

Costs and Fees

Both refinance types typically carry similar closing costs, which can range from about 2% to 6% of the new loan amount. Common fees include:

• Origination or application fees
• Appraisal fee
• Title search and insurance
• Recording and escrow fees
• Underwriting and credit report fees
• Discount points (optional) to buy down the interest rate

Specific to cash-out refis:

• Higher interest rates or additional lender-specific fees are common.
• If the new LTV exceeds 80%, you may need private mortgage insurance (PMI) or an FHA/VA product with different rules.

Tax note: Cash received from a cash-out refinance is loan proceeds—not income—and is generally not taxable. Interest deductibility may be limited depending on how the cash is used and recent tax law changes; consult a tax advisor for your situation.

Step-by-Step Process

Whether you choose a rate-and-term or cash-out refinance, the process is similar:

• Define your goal: lower rate, shorten term, or access cash.
• Check your credit score and debt-to-income ratio to estimate qualification odds.
• Estimate your home’s current value to calculate potential LTV and cash available.
• Shop multiple lenders for rates, fees, and requirements (ask for Loan Estimates).
• Apply and submit documentation (income, assets, title, payoff info).
• Order appraisal and title search—lenders generally require an appraisal.
• Underwriting: lender verifies documents and issues approval.
• Close the loan, sign documents, pay closing costs (or roll into loan if allowed), and receive funds (for cash-out).
• New mortgage begins; old mortgage is paid off by the new lender.

Common Pitfalls to Avoid

• Not calculating the breakeven point: If closing costs exceed your expected savings before you move or refinance again, the refinance may not be worth it.
• Extending loan term without considering total interest: Paying less monthly could cost you more interest over time.
• Using cash-out funds for non-essential, depreciating purchases (e.g., a vacation) rather than investments or home improvements.
• Overleveraging your home: taking too much cash can reduce equity and increase risk if property values fall.
• Failing to shop lenders: rates and fees vary significantly—get multiple Loan Estimates.
• Ignoring PMI: if your LTV goes above typical thresholds, PMI can add months or years of extra cost.

Short FAQ

Q: How much can I cash out?
A: Maximum cash-out depends on loan type and lender. Conventional loans often cap cash-out at 80% LTV, while FHA and VA programs may allow higher LTVs with additional requirements. Check specific guidelines and your home’s appraised value.

Q: Will refinancing always lower my monthly payment?
A: Not always. A lower interest rate or longer term usually reduces monthly payments, but cash-out refinancing increases your principal, which can raise payments. Always compare new payment vs. total costs.

Q: How long before I recoup closing costs?
A: Divide your closing costs by the monthly savings to estimate breakeven months. If you plan to stay in the home longer than that period, the refinance is more likely to be beneficial.

Q: Does a cash-out refinance hurt my credit?
A: Applying for any mortgage triggers a hard credit inquiry, which may cause a small short-term dip. If you pay down higher-interest debts with the cash-out, your credit utilization could improve, helping your score over time—assuming you manage credit responsibly.

Choosing between a rate-and-term refinance and a cash-out refinance comes down to your financial goals, how long you plan to stay in the home, and how much equity you want to preserve. Carefully compare costs, shop lenders, and run the breakeven math before deciding.

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