Refinancing a loan involves replacing an existing loan by paying off the debt with a new one. Ideally, the new loan has better terms or features to make the process worthwhile. This can help save you money in the long term or make your life easier in other ways.
How refinancing a loan works
According to Justin Pritchard, CFP, “you can refinance a home loan, an auto loan or just about any other debt.” Consumers typically seek to do this to obtain more favorable borrowing terms in response to shifting economic conditions. For example, if your financial situation has worsened since taking out the original loan, you may be able to stretch out the term of the refinanced loan to lower your monthly payments. If your credit score has improved, you may be able to get a rate reduction. Just remember, refinancing will not reduce or eliminate your original loan balance. In fact, there’s a risk it could grow. “This might occur if you do a cash-out refinance where you take cash for the difference between the refinanced loan and what you owe on the original loan, or when you roll your closing costs into your new loan rather than pay them upfront,” Pritchard writes.
Types of refinancing
There are multiple types of refinancing options, some of which may better suit your needs than others. According to financial reporter Alexandra Twin, the most common type is rate-and-term refinancing, which occurs when a new loan with a lower interest rate pays for and replaces the original one. Another option is cash-in refinancing. Twin says this “allows the borrower to pay down some portion of the loan for a lower loan-to-value ratio or smaller loan payments.” Other options include cash-out refinancing, which can increase your total loan amount while giving you immediate access to cash, and consolidation refinancing. Work closely with a professional at your financial institution to determine the best option for your personal situation.
When refinancing makes sense
There are four common reasons to refinance a loan. The first is that your credit score has improved — perhaps because you have been diligent in paying off the very same loan you wish to refinance. NerdWallet writer Steve Nicastro says if your credit has moved into a higher tier, such as above 720, you probably qualify for lower interest rates. Refinancing can thus save you money.
Another common reason to refinance a loan is to extend your repayment term. This lowers your monthly payments, leaving you with more money left over after you’ve paid all your expenses. However, you need to weigh that benefit against paying more in total interest and being in debt for a longer period of time.
If you feel your current loan is too long and you can handle paying more every month, you can refinance to a shorter-term loan to reduce total interest fees. And if your loan has a variable interest rate, Nicastro says refinancing to a fixed rate “will result in consistent monthly payments and provide more certainty in your budget.”
Before shopping for rates and terms at financial institutions and online lenders, talk with your current lender. It may be willing to work with you to offer you a better deal than your existing loan.