Refinance Definitions and Examples

Pros and Cons of Refinancing

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Refinancing moves debt from one loan to another. Westend61 / Getty Images

Things change. Sometimes that means a loan needs to change, and refinancing is the way to do that. To refinance a loan is to replace it with a new loan, usually a loan with better features. That doesn’t mean the debt goes away – it just gets moved to a different loan.

What is Refinancing?

Refinancing is the process of swapping out loans, moving debt to a different loan or lender. The process is briefly described below:

  1. You’ve got an existing loan
  2. You apply for a new loan
  3. The new loan pays off the existing loan
  4. You’re now left with the new loan

Why do People and Businesses Refinance?

Refinancing is a time-consuming process, and it can be expensive. So why go through the process? There are several potential benefits of refinancing.

Save money: a common reason for refinancing is to save money on interest costs. This generally requires that you refinance into a loan with a lower interest rate than your existing interest rate. Especially with long-term loans and large dollar amounts, lowering the interest rate can result in significant savings.

Improve cash flow: refinancing can lead to lower payments (such as your required monthly mortgage payment). This makes cash flow management easier and leaves more money in the budget for other monthly expenses. When you refinance, it’s often the case that you extend the amount of time that you’ll repay a loan – this means lower monthly payments.

A lower interest rate (with all other things staying the same) can also lead to lower monthly payments. However, simply extending the life of a loan can actually mean you’ll pay more for the loan over the long term.

To see how interest rates and your loan term affect cash flow, see how to calculate loan payments.

Shorten your loan term: you can also refinance into a shorter term loan. For example, you might have a 30-year home loan, but that loan can be refinanced into a 15-year home loan. This might make sense if you intend to make larger payments to get rid of the debt more quickly. Of course, you can also just make extra payments without refinancing (and that might make more sense because you’d avoid additional closing costs).

Consolidate debts: if you have multiple loans, it might make sense to consolidate those loans 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: even if you don’t get a lower interest rate or monthly payment, it can make sense to refinance for other reasons. For example, if you have a variable rate loan, you might prefer to get a different loan with a fixed rate. This would make sense if rates are low but you expect them to rise.

Pay off a loan that’s due: some loans have to be repaid on a specific date, and you might not have the funds available to completely pay off the loan. In those cases, it might make sense to refinance the loan – pay it off with a new loan – and take more time to pay off the new loan.

For example, some business loans are due after 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.

Disadvantages of Refinancing a Loan

Refinancing is not always a good idea. Even if you get a lower interest rate or monthly payment, it could be a mistake to get rid of your existing loans. Evaluate the pros and the cons before you move forward.

Transaction costs: refinancing can be expensive. Especially with loans like home loans, you’ll pay closing costs which can add up to thousands of dollars. You want to make sure you’ll more than break even before you pay those costs. Even simpler loans from online lenders can include processing and origination fees.

Additional interest costs: when you stretch out a loan over a longer period of time, you pay more interest.

You might enjoy lower monthly payments, but that benefit can be erased by the higher lifetime cost of borrowing. Run some numbers to see how much it really costs you to refinance. Get familiar with loan amortization and see how your interest costs change with different loans.

Lost benefits: some loans have important features that will go away 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 forgiven if your career involves public service. Likewise, a fixed-rate loan might be ideal if interest rates skyrocket – even if you temporarily get a lower rate with a variable rate loan.

What Doesn’t Change

Debt: when you refinance, some things change and some things don’t. You still have debt – the exact same amount as before (unless you increase the debt due to closing costs or taking cash out).

Collateral: if you used collateral for the loan, that collateral will probably still be at stake (and required) for the new loan. For example, refinancing your home loan means you could still 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.

Payments: in most cases, you monthly payment will change when you refinance. You’ve got a brand new loan, and the payments are calculated with that loan balance, term, and interest rate. To avoid getting caught by surprise, learn how to model a loan yourself (it’s easy with online spreadsheets).