What it means
The name tells you what changes: the rate and the term. The borrower keeps the same property and about the same debt, but the loan contract is rewritten on better or more suitable terms.
This is different from a cash-out refinance, where the new loan is larger than the old one and the difference is paid to the borrower. The most common reason is a fall in market interest rates since the original loan was taken.
A lower rate cuts the interest charged each month, which reduces the payment or shortens the time needed to clear the debt. Others refinance because their credit has improved, because they want to move from a variable to a fixed rate, or because they want to shorten a 30-year loan to 15 years.
The new loan is not free. Lenders charge fees for arranging it, valuing the property and registering the new security, and these costs can add up to a few per cent of the loan.
The sensible test is whether the savings over the time you will keep the loan are bigger than those costs. That test is usually expressed as a break-even period: the number of months it takes for the monthly saving to repay the up-front costs.
If you plan to sell or refinance again before that point, the refinance loses money. If you will stay well beyond it, the refinance is a clear gain.
The nuance is that stretching the term can reduce the monthly payment while increasing the total interest paid over the life of the loan. Restarting a 30-year clock after ten years of repayments feels cheaper each month but can cost far more overall.
Always compare total cost as well as the monthly figure.
In practice
Real-world examples.
Example
A teacher who took a mortgage when rates were high sees them fall by a full percentage point. She refinances her $250,000 balance into a loan at the lower rate for the same remaining term. Her payment falls and she plans to stay in the home for at least ten years.
Example
A couple with a variable-rate loan worry about future rate rises. They refinance into a fixed-rate loan of the same size, accepting a slightly higher starting rate in exchange for certainty. Their household budget now has a payment they can plan around.
Example
A self-employed consultant whose income has grown refinances a 30-year loan into a 15-year loan at a lower rate. The monthly payment rises, but the loan will be cleared in half the time. He saves a large sum in interest over the life of the loan.
Formula
Calculation
Monthly saving = old monthly payment - new monthly payment
Break-even months = total closing costs / monthly saving
A homeowner owes $300,000 and pays about $2,000 a month. By refinancing into a lower rate with the same balance, the new payment falls to about $1,800 a month, and the closing costs are $4,800. The monthly saving is 2,000 - 1,800 = $200. The break-even period is 4,800 / 200 = 24 months, so after two years the homeowner is ahead, and over five years the net gain is (60 x 200) - 4,800 = 12,000 - 4,800 = $7,200.Case study
Seen in the real world.
Willowmere Homes is an illustrative, fictional mortgage broker that advises a fictional customer, Daniel, who owes $400,000 on a loan with 25 years left. His payment is $2,600 a month, and he hopes to cut it.
The broker found a new loan with a lower rate and the same 25-year term that would cost $2,350 a month, with closing costs of $6,000. The saving was $250 a month, so the break-even was 6,000 / 250 = 24 months. Daniel said he expected to stay for at least eight years, so the broker recommended going ahead.
Three years later Daniel had saved 36 x 250 = $9,000 before costs, a net gain of $3,000 after the $6,000 fees. The illustrative lesson is that a refinance should be judged by its break-even period and the time you will hold the loan.
Watch out
Common mistakes.
- Focusing only on the lower monthly payment and ignoring the closing costs that must be recovered.
- Extending the loan term without checking how much extra interest it will add over the full life of the loan.
- Refinancing shortly before selling the property, so the savings never repay the fees.
Questions
People also ask.
What is the difference between a rate and term refi and a cash-out refi?
A rate and term refi keeps the loan roughly the same size and changes only the rate or length, while a cash-out refi increases the loan and pays out the difference.
Do I need to pay closing costs?
Usually yes, though some lenders roll them into the loan or offer a slightly higher rate in exchange for lower upfront fees.
When does a refinance make sense?
Typically when the rate falls enough, or your needs change enough, that the savings over the time you will keep the loan are larger than the cost of arranging it.
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