If you have a loan that’s too expensive or too risky to live with, you often can refinance into a better loan. Things may have changed since you borrowed money, and several ways may be available for you to improve your loan’s terms. Whether you’ve got a home loan, auto loans, or other debt, refinancing allows you to shift the debt to a better place.
What Is Refinancing?
Refinancing replaces an existing loan with a new loan that pays off the debt of the old loan. The new loan should have better terms or features that improve your finances. The details depend on the type of loan and your lender, but the process typically looks like this:
- You have an existing loan you would like to improve in some way.
- You find a lender with better loan terms, and you apply for the new loan.
- The new loan pays off the existing debt completely.
- You make payments on the new loan until you pay it off or refinance it.
Refinancing can be time-consuming and expensive, and a new loan might be missing attractive features that an existing loan offers. However, refinancing has several potential benefits:
A common reason for refinancing is to save money on interest costs. To do so, you typically need to refinance into a loan with an interest rate that is lower than your existing rate. Especially with long-term loans and large dollar amounts, lowering the interest rate can result in significant savings.
Refinancing can lead to lower required monthly payments. The result is easier cash flow management and more money available in the budget for other monthly expenses. When you refinance, you often restart the clock and extend the amount of time you’ll take to repay a loan. Since your balance is most likely smaller than your original loan balance and you have more time to repay, the new monthly payment should decrease.
Shorten the loan term.
Instead of extending repayment, you also can refinance into a shorter-term loan. For example, you might have a 30-year home loan, and that loan can be refinanced into a 15-year home loan that typically will come with a lower interest rate. Of course, you can also just make extra payments without refinancing to avoid paying closing costs and keep the flexibility of not being required to make those larger payments.
If you have multiple loans, it might make sense to consolidate them into one single loan, especially if you can get a lower interest rate. It’ll be easier to keep track of payments and loans.
Change your loan type.
If you have a variable-rate loan, you might prefer to switch to a loan at a fixed rate. A fixed interest rate offers protection if rates are currently low, but expected to rise.
Pay off a loan that’s due.
Some loans, particularly balloon loans, have to be repaid on a specific date, but you might not have the funds available for a large lump-sum payment. In those cases, it might make sense to refinance the loan—using a new loan to fund the balloon payment—and take more time to pay off the debt. For example, some business loans are due after just a few years, but they can be refinanced into longer-term debt after the business has established itself and shown a history of making on-time payments.
Refinancing is not always a wise move. Upfront costs might be too high to make it worthwhile, and sometimes the benefits of a current loan outweigh the savings associated with refinancing.
Refinancing can be expensive. Especially with loans like home loans, closing costs can add up to thousands of dollars. You want to make sure you’ll come out ahead before you pay those costs. Other types of loans, including loans from online lenders, can include processing and origination fees.
Higher interest costs.
Refinancing can backfire. When you stretch out loan payments over an extended period, you pay more interest on your debt. You might enjoy lower monthly payments, but that benefit can be offset by the higher lifetime cost of borrowing. Run some numbers to see how much it really costs you to refinance. Do a quick loan amortization to see how your interest costs change with different loans.
Some loans have useful features that will be eliminated if you refinance. For example, federal student loans are more flexible than private student loans if you fall on hard times. Plus, federal loans might be partially forgiven if your career involves public service. Likewise, keeping a fixed-rate loan might be ideal if interest rates skyrocket—even though you’d temporarily get a lower rate with a variable-rate loan.
What Doesn’t Change
While refinancing can change the terms of a loan, some aspects of loans do not change with refinancing.
Your loan balance will not change unless you take on more debt while refinancing. It’s possible to do cash-out refinancing or roll your closing costs into your loan, but that just increases your debt burden.
If you used collateral for the loan, that collateral probably will still be required for the new loan. For example, refinancing your home loan means you still could lose the home in foreclosure if you don’t make payments. Likewise, your car can be repossessed with most auto loans. Unless you refinance into a personal unsecured loan, the collateral is at risk. In some cases, you actually can increase the risk to your collateral when you refinance. Some states allow nonrecourse home loans to become recourse loans after refinancing.
When to Refinance
Saving money is an obvious motivation for refinancing, but in at least a couple of specific instances, you’d be wise to look into refinancing a loan.
Improved credit score
If you’ve recently come out of a difficult financial situation that damaged your credit score, you might have a loan or two with a high interest rate. Maybe you lost your job or got divorced or had a medical emergency that left you buried in debt. Maybe you even had to file for bankruptcy. Regardless of the reason, if you had to get a car loan or some other loan while your credit score was low, your interest rate will reflect that. The good news is that once you’ve improved your credit score, you likely can refinance those loans at a significantly lower rate.
If you have a lot of equity in your home, you can reinvest that equity in your home to make some long-needed repairs or just to renovate the property with an additional room, a swimming pool, or whatever you desire. Assuming your credit is good, you can do what is called a cash-out refinance.
Let’s say you purchased a home for $250,000 and it now has a market value of $300,000. When you took out the mortgage, you made a down payment of $50,000 and you’ve paid another $50,000 toward the principal. That means you owe $150,000 on a home with a market value twice that amount. If you need $25,000 for home repairs, you could refinance your mortgage for $175,000. The $150,000 you still owe on the current mortgage would be paid off, the extra $25,000 would be paid to you, and you’d have a new car loan payoff amount of $175,000. Depending on available interest rates and the length of the new mortgage, you might even be able to lower your monthly payments with this kind of transaction.
How to Refinance
Refinancing is like shopping for any loan or mortgage. First, take care of any issues with your credit so that your score is as high as possible. Then shop around to find the best rate and the best terms.
Get a few quotes before inquiring with your current lender. For example, if you’re thinking of refinancing your home, see what kind of rates you can get from competitors before inquiring about what your current lender is willing to do. If your current lender wants to keep your mortgage, you might be able to get even better terms.
What Is a Refinance?
A refinance occurs when an individual or business revises the interest rate, payment schedule, and terms of a previous credit agreement. Debtors will often choose to refinance a loan agreement when the interest rate environment has substantially changed, causing potential savings on debt payments from a new agreement.
How Refinancing Works
A refinance involves the reevaluation of a person or business’s credit terms and credit status. Consumer loans typically considered for refinancing include mortgage loans, car loans, and student loans.
Business investors may also seek to refinance mortgage loans on commercial properties. Many business investors will also evaluate their corporate balance sheets for business loans issued by creditors that could benefit from lower market rates or an improved credit profile.
Refinancing occurs when a person or business changes the interest rate, payback schedule, and terms of an already existent agreement
The current rate environment is typically a key catalyst for loan refinancing. Other factors that trigger a refinance can be an improved credit profile or a change in long-term financial plans. Here are some key takeaways:
- A refinance occurs when a previous loan has been revised in terms of the interest rate, payment schedule, and terms.
- A refinance involves the reevaluation of a person or business’s credit terms and credit status.
- Consumer loans often considered for refinancing include mortgage loans, car loans, and student loans.
- A common goal is to pay less interest over the life of the loan. Borrowers may also want to change the duration of the loan or switch from a fixed-rate to an adjustable-rate mortgage, or vice versa.
Types of Refinance Loans
There are several different types of refinancing options. The type of loan a borrower decides on depends on the needs of the borrower.
The most common type of refinancing is called the rate-and-term. This occurs when the original loan is paid and replaced with a new loan requiring lower interest payments.
Cash-outs are common when the underlying asset collateralizing the loan increases in value. The transaction involves withdrawing the value or equity in the asset in exchange for a higher loan amount.
In other words, when an asset increases in value on paper, you can gain access to that value with a loan rather than by selling it. This option increases the total loan amount but gives the borrower access to cash immediately while still maintaining ownership of the asset.
The cash-in refinance allows the borrower to pay down some portion of the loan for a lower loan-to-value ratio or smaller loan payments.
In some cases, a consolidation loan may be an effective way to refinance. A consolidation refinancing can be used when an investor obtains a single loan at a rate that is lower than their current average interest rate across several credit products.
This type of refinancing requires the consumer or business to apply for a new loan at a lower rate and then pay off existing debt with the new loan, leaving their total outstanding principal with substantially lower interest rate payments.
Special Considerations for Refinance
Interest rate environments are cyclical and as such are followed closely by consumers and businesses for new credit as well as credit refinancing. National monetary policy, economic cycle, and market competition can be key factors causing interest rates to increase or decrease for consumers and businesses.
During economic valleys, interest rates may be lowered to help stimulate consumer spending and business investment. Economies in an expansion will typically see interest rates rising as the economy improves.
These factors can influence interest rates across all types of credit products including both non-revolving loans and revolving credit cards. In a rising rate environment debtors with floating-interest-rate products can expect to see their interest rates automatically increased and vice versa with a decreasing rate environment.
Some fixed-term loans have penalty clauses (“call provisions”) that are triggered by an early repayment of the loan, in part or in full, as well as “closing” fees. There will also be transaction fees on the refinancing. These fees must be calculated before embarking on a loan refinancing, as they can wipe out any savings generated through refinancing. Penalty clauses are only applicable to loans paid off prior to maturity. If a loan is paid off upon maturity it is a new financing, not a refinancing, and all terms of the prior obligation terminate when the new financing funds pay off the prior debt.
If the refinanced loan has the same interest rate as previously, but a longer term, it will result in a larger total interest cost over the life of the loan, and will result in the borrower remaining in debt for many more years. Typically, a refinanced loan will have a lower interest rate. This lower rate, combined with the new, longer term remaining on the loan will lower payments.
A borrower should calculate the total cost of a new loan compared to the existing loan. The new loan cost will include the closing costs, prepayment penalties (if any) and the interest paid over the life of the new loan. This should be lower than the remaining interest that will be paid on the existing loan to see if it makes financial sense to refinance.
In some jurisdictions, varying by American state, refinanced mortgage loans are considered recourse debt, meaning that the borrower is liable in case of default, while un-refinanced mortgages are non-recourse debt.