Rate-and-term and cash-out refinancing: What’s the difference?

So, you want to refinance your home. The great news is that there are several refinancing options to choose from. However, the type of refinance you select will depend on what you want to accomplish.

Are you trying to reduce your mortgage interest rate and change the loan terms? Or do you need cash from the equity in your home for an upcoming renovation project? The reasons borrowers decide to refinance greatly vary, so it’s important to thoroughly research your options before choosing one to move forward with.

When you’re refinancing a mortgage, two popular choices are a rate-and-term refinance and a cash-out refinance. In order to make the best decision for your unique situation, this article will walk you through how they work, the benefits of each, and how to determine which refi option is right for you.

What is rate-and-term refinancing?

A rate-and-term refinance, also known as a no cash-out refi, gives borrowers the opportunity to change the rate and/or the terms of their existing mortgage without advancing any new funds. This is probably what most people think of when they hear the term “refinancing.” Essentially, you’re replacing your current mortgage with a new one with better terms and without changing the principal balance. Borrowers who choose a rate-and-term refi are primarily driven by a drop in market interest rates.

For example, let’s say you started with a 30-year mortgage at a 6% interest rate. You have 20 years left on the mortgage, but you notice that interest rates are dropping. Rather than keeping the same loan, you decide to refinance to a 15-year mortgage with a 5% rate. In this case, you’re shortening the time it will take to pay off your mortgage and pay less interest overall!

You may also decide to get another 30-year mortgage, resetting the clock (so to speak), and reducing your monthly payments.

Generally, in order for a borrower to benefit from a rate-and-term refinance, lower interest rates must be available to them. While you can’t control the economy and fluctuating rates, you do have control over your debt-to-income ratio (DTI) and credit score. Most lenders require a borrower to have a credit score of 620 or higher to qualify. You’ll also want to have a DTI ratio of 50% or lower. If you have defaulted on payments since receiving your first mortgage, or you’ve taken out other loans, chances are you’ll probably be facing higher interest rates when you apply to refinance.

However, if you’re finances are in order or you take the time to increase your credit score and decrease other debts, you’ll be able to benefit from a rate-and-term refinance.

Rate-and-term refinancing benefits

• Reduce monthly payments
• Lower your interest rate
• Change your loan type (for example, change from an adjustable-rate to fixed-rate or an adjustable-rate loan)
• Decrease (or reset) your loan term

What is cash-out refinancing?

When it comes to a cash-out refinance, you’re still replacing your current mortgage with a new one that has different terms. The difference is that you’ll be taking out a larger loan than what is left to pay on your home in order to receive a cash surplus.

Cash-out refinancing can be a great option for homeowners who have built equity in their home. In many cases, you can’t receive more than 80% of a home’s value in cash in order to keep at least 20% equity in the home. The amount you’re eligible to take out is also impacted by your creditworthiness, property type, and your existing mortgage.

Let’s use an example: say your home is currently valued at $300,000 and you have a balance of $150,000 remaining on your initial mortgage. That means you have $150,000 in home equity (or 50% of the home’s value). If you need to keep 20% of the equity in the home, you’re eligible to take out 30% or $90,000 of the home’s value in cash.

In this scenario, your cash-out refinance turns your first mortgage into a new one that’s $240,000. That’s the $150,000 you already owe, plus $90,000 in cash.

Cash-out refinancing benefits:

• Get cash to use toward other financial goals, home improvements, and more
• Lower interest rate compared to HELOC and home equity loans

Rate-and-term vs. cash-out refinance

The most straightforward refinance option is the rate-and-term refi. No additional money exchanges hands, aside from the fees associated with the new loan. Your mortgage amount remains the same — you’re simply trading the current mortgage for a new one with better terms. You’re also able to qualify with a higher loan-to-value ratio. This is the amount of the loan divided by the property’s appraised value.

In comparison, a cash-out refinance comes with a larger mortgage than the previous one. On top of new loan terms, you also receive a lump cash sum from the equity in your home. However, many lenders have stricter requirements that borrowers must meet in order to be eligible because this refinancing option carries a greater risk to the lender. This type of refinance works best for homeowners whose overall property value has increased or those who are further along in their current mortgage and have already paid a significant part of its equity.

Which mortgage refinancing option is right for you?

When all is said and done, the type of refinance you choose will depend on your financial goals. If you desire a lower rate, better terms, or reduced monthly payments, then a rate-and-term refinance may be the right choice. If you’re looking to pocket some cash to put toward debt consolidation or home improvement projects, a cash-out refinance can get you the funds you need.

It's always best to consult with your lender to learn which refinance options are available and what might be best for your personal needs. Remember, you don’t have to refinance your mortgage with the original lender. Be sure to shop around to see which mortgage refinance lenders are able to offer you the best possible deal.