Cash-out refinance vs. rate-and-term mortgage refinance: What are they, and which one should you choose?

When you refinance your mortgage, you're trading your current mortgage for a new mortgage. You have two main types of refinances to choose from: a rate-and-term refinance and a cash-out refinance.

What is a rate-and-term refinance?

A rate-and-term refinance is probably what you think of when you hear the term "refinance." You replace your initial mortgage with a new one that comes with better terms.

Your refinanced mortgage brings a new interest rate and a different required monthly payment. You'll also probably refinance into a new term length.

Maybe you originally took out a 30-year mortgage at a 4% interest rate. You have 25 years left on your mortgage, but instead of keeping the same loan, you refinance into a mortgage with a 15-year term and 3% rate. This way, you'll pay off your mortgage sooner and pay less in interest.

What is a cash-out refinance?

With a cash-out refinance, you'll still replace your old mortgage with a new one that has different terms. But you'll actually take out a loan larger than what you have left to pay on the home so you can receive the surplus in cash.

A cash-out refinance can be a good option if you've built equity in your home. A lender typically won't let you receive more than 80% of your home's value in cash, so you'll keep at least 20% equity in the home.

Let's say your home is valued at $200,000, and you have $100,000 left to pay on your initial mortgage. This means you have $100,000 in home equity, or 50% of the home value.

If you need to keep 20% of your equity in the home, then you're eligible to take out 30% of the value in cash, or $60,000.

You refinance into a mortgage for $160,000 — that's $100,000 that you already owed on the home, and $60,000 in cash.

How to choose between a rate-and-term refinance and a cash-out refinance

The pros of a rate-and-term refinance

• It's more affordable than a cash-out refinance. Your interest rate and closing costs will probably be less expensive with a rate-and-term refinance. You're also taking out a larger loan with a cash-out refinance so you can receive some in cash, so you'll pay more interest in the long run.
• It's easier to qualify. Because cash-out refinances are riskier for lenders, companies usually set stricter eligibility requirements. You might need more equity in your home or a higher credit score to get a cash-out refinance than a rate-and-term refinance. (This isn't always the case, though. If you're on the fence about which type of refinance to get, talk to a few lenders about their requirements.)

The pros of a cash-out refinance

• You can use the cash to achieve other goals. Use the money to make home improvements, pay off high-interest debt, or put your child through school. There are no legal limits on how you can spend the money you receive from a cash-out refinance. But because cash-out refinances can be expensive, it may not be worth it to refinance to cover unnecessary expenses.
• You'll get a lower rate than you would with a home equity loan or HELOC. Maybe you already know you want to put your home equity toward different expenses, but you're not sure which route to take. Home equity loans and HELOCs are two other types of home loans that let you tap into the equity of your home. If you're trying to choose between a cash-out refinance, home equity loan, or HELOC, know that cash-out refinance rates are usually lower.

Your choice between a rate-and-term refinance and a cash-out refinance will come down to your ultimate goal behind refinancing. Do you want new terms so you can pay less, or do you want to pocket cash so you can achieve other financial goals?