Key refinance terms
Amortization describes the process in which a borrower pays off debt over time through consistent, fixed payments. These cover the debt itself — in this case, the amount you’re borrowing for your refinance— plus interest. While you'll always pay the same total amount for a fixed-rate refinance, the amount you'll pay for interest will get smaller over time while the amount you pay toward the actual loan (known as the "principal") will get larger. You can find your list of payments, and how they’re allocated, on what’s known as an amortization schedule.
APR (Annual Percentage Rate)
APR (annual percentage rate) is a way to describe the total cost of your loan. It includes your interest rate as well as additional fees for your refinance (such as discount points) all expressed as one percentage. Because of this, your APR is a more accurate indication of what you’ll pay than just the interest rate. The higher your APR, the more you’ll pay over the life of your loan.
In a cash-out refinance, you refinance to a mortgage that’s more than what you originally owed and get the difference in cash. The cash comes from the equity you’ve gained in your home as it’s increased in value. Cash-out refinances typically have higher interest rates, but they can be an easy way to get cash to use for things like making home improvements, paying college tuition, or consolidating high-interest debt.
Closing costs are the expenses you pay to refinance. These can include a lender’s origination and underwriting fees, an appraisal fee, title search and insurance costs, and more. Closing costs can either be paid upfront in full or added to the balance of your loan — known as “rolling in”—so you don't have to pay anything out of pocket. You can even avoid paying closing costs at all in exchange for a higher interest rate. If you’d like more information about closing costs you can check out our article What Are Mortgage Refinance Closing Costs?.
Debt-to-income (DTI) ratio
Your debt-to-income (DTI) ratio is a calculation that compares your debt to your income to show lenders your ability to repay your loan. DTI is calculated by dividing your monthly debt payments—such as credit cards, an auto loan or student loans—by your gross monthly income, which includes your wages and income from other sources like alimony, a rental property or Social Security. Most lenders prefer a DTI ratio of less than 50%.
Discount points (also known as mortgage points) allow you to lower your rate by paying more upfront. Generally, one discount point costs 1 percent of the amount you’re borrowing and decreases your rate by 0.25 percent. You can buy more than one discount point if it makes sense for your situation. If you're planning to stay in your home for a longer period of time, it may be a good idea to buy points and get savings since you'll be able to recoup the cost and start saving on your home faster.
Essentially, escrow is the account holding the money you need to refinance, such as your homeowners insurance and property taxes, on behalf of you and your lender while the lender moves you through the process. After you complete the refinance, your lender likely will continue to escrow these funds to pay your premiums and property taxes for you.
Home equity describes the value of your home minus the balance remaining on your mortgage. You can tap into your home’s equity and borrow against it in a cash-out refinance, home equity loan or home equity line of credit (HELOC).
Your interest rate represents your borrowing cost expressed as a percentage. Your credit determines your interest rate, so generally, the better your credit report and score, the lower your rate will be. If your score between all 3 credit bureaus is 740 or above, you will be in the top credit score bracket for pricing.
The loan principal is the amount you borrow minus the interest you’ll need to pay on it. This number is most often used in your monthly payments, which are a combination of your principal plus interest. As your loan amortizes, you pay more toward your principal and less toward interest.
Loan-to-value (LTV) ratio
The loan-to-value (LTV) ratio compares the amount of your loan (the amount you’re borrowing) to the home’s value. If your LTV ratio is higher than 80 percent, you’ll need to pay private mortgage insurance (PMI), which adds to your monthly mortgage payment. When you refinance, you’ll need at least 20 percent equity in your home in order to avoid these insurance premiums.
Preapproval and prequalification are processes in which you’re evaluated for a refinance, and they can determine how much you qualify for and at what terms. The difference is, a preapproval is a commitment from a lender — based on detailed information you provided — to refinance, whereas a prequalification is an indicator of the likelihood you’ll be approved.
A rate-and-term refinance is a conventional refinance whereby you change either the interest rate, the term or both on your existing mortgage, without accessing any cash or equity.
Title insurance is an insurance policy covering defects with a home’s title, or ownership. There are two kinds of title insurance: a lender’s policy, which covers only your lender, and is generally required; and an owner’s policy, which covers you, and may be optional.