How to choose the right kind of refinance for you

There are many reasons refinancing is a smart financial move, from lowering your mortgage payments to eliminating private mortgage insurance once you reach the minimum equity requirements. Each borrower’s goals and financial picture is unique, which means there isn’t one type of refinancing that makes sense for everyone.

There are two general types of mortgage refinancing:

Rate-and-term refinance

Rate-and-term refinance definition

Rate-and-term refinancing is when you replace your existing mortgage with a new mortgage that has a different interest rate, a different loan term (the length of your mortgage) or both.

Refinance into a lower interest rate

For borrowers with strong credit scores (a minimum of 700, but the higher the better) and low loan-to-value ratios (LTV), this is an excellent time to shop around for low interest rates. More lenders are advertising rates in the low 3s and even 2s, but they’re also raising minimum requirements. You can compare refinance offers on Bankrate.

Before you apply for a refinance, check your credit score and LTV (use Bankrate’s LTV calculator). An ideal scenario for conventional refinancing is a FICO score above 700 and an LTV below 60 percent. Borrowers can qualify for refinancing with LTVs of 80 percent or lower. Anything more than 80 percent and private mortgage insurance kicks in.

Refinance into a different loan term

You can also change the term of your mortgage. If you want to pay off your mortgage faster (and reduce the total amount of interest you pay), you can refinance into a shorter loan. Of course, this doesn’t change the amount you owe, which means your monthly payments will be higher.

Let’s say you only have 10 years left on your existing 30-year mortgage. You can refinance into another 30-year fixed-rate mortgage with a lower interest rate. This will reduce your monthly payments, but you will pay more in total interest because you’re resetting your loan. To maximize your total savings, you should lower your interest rate and shorten the term of your mortgage.

Here are three scenarios that show what happens when you reduce the rate on a $200,000 loan to 3.5 percent with a 30-year, 15-year and 10-year fixed rate mortgage.

30-year fixed mortgage 15-year fixed mortgage 10-year fixed mortgage
Monthly payment $898.09 $1,429.77 $1,977.72
Total interest paid $123,312.18 $57,357.710 $37,326.08
Total cost of the loan $323,312.18 $257,357.71 $237,326.08

If your goal is to reduce interest on the life of the loan, then the 10-year fixed-rate option is the best one. Keep in mind that you might get a better interest rate on a shorter loan, which would help ease those monthly payments and further trim your total interest debt.

Cash-out refinance

Cash-out refinance definition

A cash-out refinance allows borrowers to tap equity in their home while also lowering their mortgage interest rate. Borrowers refinance their mortgage (the same way you would with a rate-and-term refinance) and get a check for the amount they borrow at closing. The new balance is higher because it reflects the borrowed amount, plus any closing costs you roll into the loan.

Typically, lenders cap the amount you can borrow at 80 percent of the equity you have in your home, which would leave 20 percent intact.

For example, if your home is currently appraised at $300,000 and you owe $100,000, you can get up to $140,000 in cash out, which would leave the minimum 20 percent equity left in your home.

A cash-out refinance may make sense for borrowers who want to make home improvements or need emergency funds with a relatively low interest rate. However, experts warn against tapping your equity for lifestyle purchases, such as vacations or entertainment.

In today’s lending environment, qualifying for a cash-out refinance is tougher than it was before the coronavirus pandemic. Borrowers with higher credit scores and more equity might stand a better chance of qualifying for this type of refinance.

Featured image by Roberto Westbrook of Getty Images.

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