Quick overview
A refinance is replacing one mortgage with another. The two most common ways homeowners refinance are a rate/term refinance and a cash‑out refinance. Both replace your existing mortgage, but they have different goals, costs, eligibility rules, and tax considerations.
This guide explains the differences, when each option makes sense, how lenders evaluate them, the typical costs and timelines, tax rules that often matter to homeowners, and practical examples and strategies I use in practice.
Primary difference in plain terms
- Rate/Term Refinance: You get a new loan with a better interest rate and/or different term (for example, switching from a 30‑year to a 15‑year mortgage) and you do not draw cash out. The loan amount generally equals the payoff balance plus closing costs.
- Cash‑Out Refinance: You borrow more than you owe, the lender pays off the old loan, and you receive the difference in cash. You increase your mortgage balance and convert home equity into liquid funds.
Both are secured by your home, but they affect your debt level, monthly payment, and long‑term interest paid in different ways.
When to choose each option
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Choose a rate/term refinance when your main goal is lower monthly payments, a lower interest rate, or paying off the mortgage sooner without increasing debt. Typical reasons include interest rates dropping meaningfully below your current rate or switching to a shorter term to build equity faster.
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Choose a cash‑out refinance if you need a large sum of money (home renovation, debt consolidation, education, large medical bills) and you can’t or don’t want to use other financing (HELOC, personal loan, savings). Cash‑out makes sense when the net cost of borrowing via your mortgage compares favorably to alternatives.
In my 15+ years advising homeowners, clients often pick rate/term to reduce payment pain and cash‑out when they value the lower interest rate and longer term on mortgage debt compared with credit card or personal loan rates.
Eligibility and underwriting differences
Lenders underwrite both types but view risk differently:
- Loan‑to‑Value (LTV): Cash‑out refinances typically require lower maximum LTVs (i.e., more borrower equity) than rate/term loans. Conventional cash‑out loans commonly limit LTV to 80% for primary residences; limits vary by loan program (FHA, VA, USDA have distinct rules). See the lender’s program guidelines for exact thresholds.
- Credit and income: Both require verification of credit, income, assets and employment. Cash‑out often needs stronger credit and documentation because the borrower increases total debt.
- Appraisals: Cash‑out refinances more commonly require full appraisals to determine current value; some rate/term refinances (including streamline programs like VA IRRRL or FHA Streamline in specific cases) may have relaxed appraisal rules.
For program‑specific limits and process, consult loan program pages. For general borrower guidance, the Consumer Financial Protection Bureau publishes clear comparison guidance on mortgage refinancing (ConsumerFinance.gov).
Costs and how to compare them
Both refinance types involve closing costs: origination fees, appraisal, title and recording fees, and prepaids. Typical closing costs range from about 2% to 5% of the loan amount. Important comparisons:
- Break‑even period (months to recoup costs): Divide total closing costs by monthly savings to find how many months until you recoup costs. If you plan to move before that time, refinancing may not make sense.
- Interest‑over‑life: A lower rate/shorter term saves interest. A cash‑out increases principal and may raise total interest even if the interest rate is lower.
Example break‑even (rate/term):
- Current mortgage balance: $250,000 at 4.75% (30‑year fixed)
- New rate: 3.75% (30‑year fixed)
- Monthly savings ≈ $131
- Closing costs = $4,000
- Break‑even = $4,000 / $131 ≈ 30 months
If you expect to stay in the home longer than 30 months, that rate/term refinance is likely beneficial.
Example cash‑out math:
- Current loan: $150,000
- Home value: $350,000 (LTV = 43%)
- Cash‑out amount desired: $50,000
- New loan = $200,000 (new LTV ≈ 57%)
- Even with a lower rate, you now owe more; compare monthly payment and total interest over the term to alternatives like a HELOC or personal loan.
Use a calculator to compare scenarios. Our internal Refinance Break‑Even Calculator can help with this analysis: Refinance Break‑Even Calculator (https://finhelp.io/glossary/refinance-break-even-calculator/).
Tax and accounting considerations (U.S.)
- Proceeds from a refinance (including cash‑out) are loan proceeds and generally are not taxable income. However, whether interest is deductible depends on how the funds are used and tax law.
- Under current U.S. tax rules (post‑TCJA), interest on mortgage debt is deductible only on loans used to buy, build, or substantially improve the taxpayer’s home and subject to limits on total acquisition indebtedness and mortgage balances. Interest on funds used for other purposes (e.g., paying off credit cards or buying a car) may not be deductible unless they meet the qualifying use rules. See IRS Publication 936 and the IRS home mortgage interest information for details (https://www.irs.gov/pub/irs‑pdf/p936.pdf and https://www.irs.gov/taxtopics/tc505).
Because tax treatment can materially affect the after‑tax cost of borrowing, ask a tax professional about your situation before using cash‑out funds for non‑home improvements.
Pros and cons at a glance
Rate/Term Refinance
- Pros: Lowers monthly payment or shortens term without increasing debt; may lower total interest; can remove PMI if sufficient equity.
- Cons: Closing costs; resets loan term which could extend time to full payoff if you choose a longer term.
Cash‑Out Refinance
- Pros: Access to large amounts of cash at mortgage rates (often lower than unsecured credit); may consolidate higher‑cost debt; can fund home improvements that increase property value.
- Cons: Increases mortgage balance and monthly payment; reduces home equity; could put you at higher risk if home values fall; possible loss of mortgage interest deductibility if funds used for non‑qualified purposes.
Practical steps and timing
- Calculate goals: lower payment, shorten term, or access cash? Identify the exact amount needed if cash‑out.
- Check current interest rates and get multiple rate quotes. Compare APR (which includes some fees) and not just the nominal rate.
- Run a break‑even calculation and compare total cost over the time you expect to keep the home.
- Confirm program eligibility — especially LTV limits for cash‑out and any mortgage insurance or seasoning requirements.
- Order an appraisal if required, gather pay stubs, tax returns, and bank statements.
- Lock the rate when you’re comfortable; closing typically takes 30–45 days but can be longer depending on underwriting and appraisals.
Use our Mortgage Refinance Checklist to prepare documents and avoid delays: Mortgage Refinance Checklist (https://finhelp.io/glossary/mortgage-refinance-checklist/).
Common mistakes I see with clients
- Not comparing total costs and focusing only on the nominal rate.
- Using a cash‑out refinance to pay recurring expenses (like everyday bills) rather than one‑time needs or investments—this converts short‑term consumption into long‑term secured debt.
- Overleveraging the home (taking out too much equity), leaving no cushion if market values drop.
- Forgetting to check if mortgage insurance can be removed after a rate/term refinance.
When alternatives make sense
- HELOC or home equity loan: Better for shorter‑term or smaller amounts where you want interest‑only draws and faster access. But rates are often variable.
- Personal loan: Good when you need cash quickly and don’t want to put your home at risk; usually higher interest rates and shorter terms.
- Mortgage recast: If you have a large principal payment and want lower monthly payments without refinancing, check whether your lender offers recasting.
We cover recasting and other options in related posts like Mortgage Recasting vs Refinancing: Which Is Right? and Limited Cash‑Out Refinance (https://finhelp.io/glossary/mortgage-recasting-vs-refinancing-which-is-right/ and https://finhelp.io/glossary/limited-cash-out-refinance/).
Bottom line
A rate/term refinance is for changing rate or term without increasing your debt. A cash‑out refinance converts home equity into cash, increasing your mortgage balance and changing your risk profile. Before choosing, run the numbers — including break‑even, long‑term interest cost, and tax implications — and compare alternatives. Consult a mortgage professional and a tax advisor to tailor the decision to your financial situation.
Author note and disclaimer
In my practice advising more than 500 homeowners, I’ve seen both options help people reach financial goals when chosen for the right reasons. This article is educational only and does not substitute for personalized advice. Consult a mortgage lender and a tax professional before refinancing.
Sources and further reading
- Consumer Financial Protection Bureau: Comparing mortgage refinance options (https://www.consumerfinance.gov)
- IRS Publication 936, Home Mortgage Interest Deduction (https://www.irs.gov/pub/irs-pdf/p936.pdf)
- FinHelp related posts: Refinance Break‑Even Calculator (https://finhelp.io/glossary/refinance-break-even-calculator/), Mortgage Refinance Checklist (https://finhelp.io/glossary/mortgage-refinance-checklist/), Limited Cash‑Out Refinance (https://finhelp.io/glossary/limited-cash-out-refinance/)
