Should You Refinance? The Pros and Cons of Replacing a Loan
Learn about what refinancing is and what to expect from the process
If you have a loan that’s too expensive or too risky to continue to make payments on, you often can refinance it into a better loan. Your financial circumstances may have changed since you first borrowed the money, and more beneficial loan terms may be available to you. Whether you’ve got a home loan, auto loan, or other debt, it's worth learning about what refinancing is and what benefits and risks it presents so that you can potentially shift your debt in a more manageable way.
What Refinancing Involves
When you refinance, you replace 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 of what the refinancing looks like depend on the type of loan and your lender, but the process typically unfolds as follows:
- You have an existing loan that you would like to improve in some way.
- You shop around for lenders and find one that offers better loan terms than your old loan.
- You apply for the new loan.
- If your loan is approved, the new loan pays off the existing debt completely.
- You make payments on the new loan until you pay it off or refinance it.
Find out whether your lender charges a prepayment penalty if you pay off your old loan too early. If it does, compare the costs of the penalty against the savings you will gain from the refinancing.
What Refinancing Doesn’t Change
While you can adjust certain terms of a loan when you refinance, two aspects of loans do not change during a refinancing:
- Debt: When you refinance a loan, you will not reduce or eliminate your loan balance. You could, in fact, take on more debt while refinancing. This might occur if you do a cash-out refinancing where you get cash for the difference between the refinanced loan and what you owe on the original loan or roll your closing costs into your loan.
- Collateral: If you used collateral for the loan, that collateral may still be required for the new loan. This means that you still can lose your home in foreclosure if you refinance a home loan but don’t make payments. Likewise, your car can be repossessed with most auto loans. Unless you refinance a loan into a personal unsecured loan, which doesn't use property as collateral, the collateral is at risk. In some cases, you actually can increase the risk to your property when you refinance. For example, some states allow nonrecourse home loans that don't allow lenders to take property other than the collateral to become recourse loans that let lenders hold you liable for your debt even after they take your collateral.
Advantages When You Refinance a Loan
Although a new loan might lack attractive features of an existing loan, refinancing has several potential benefits:
- Lower your interest rates. A common reason for refinancing is to lower financing costs; to do so, you typically need to refinance into a loan with an interest rate that is lower than your existing rate by qualifying for a lower rate based on market conditions or an improved credit score. Lower interest rates typically result in lower interest costs and significant savings over the life of the loan, especially with large or long-term loans.
- Change the loan term. While you can extend repayment to increase the term of the loan (but potentially pay more in interest costs), you also can refinance into a shorter-term loan. For example, you might want to refinance a 30-year home loan into a 15-year home loan that comes with higher monthly payments but a lower interest rate.
- Consolidate debts. If you have multiple loans, it might make sense to consolidate them into a single loan, especially if you can get a lower interest rate. One loan makes it easier to keep track of payments.
- Change your loan type. If you have a variable-rate loan that causes your monthly payments to fluctuate as interest rates change, you might prefer to switch to a loan at a fixed rate. A fixed-rate loan offers protection if rates are currently low but are expected to rise and results in predictable monthly payments.
- Lower your monthly payments. Whether you lower the interest rate on your loan or extend the amount of time you’ll take to repay it, your new loan payment will most likely be smaller than your original loan payment because you will have lower interest costs or more time to repay. The outcome is often a healthier monthly cash flow and more money available in the budget for other essential monthly expenses.
- 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 in order to gain more time to pay off the debt. For example, some business loans are due after just a few years but can be refinanced into longer-term debt after the business has established itself and shown a history of making on-time payments.
Instead of refinancing a loan, you can pay a little extra toward the principal each month to reduce the loan term and save a substantial amount in interest costs.
Disadvantages of Refinancing
Refinancing is not always a smart money move; the drawbacks include:
- Transaction costs: Refinancing can be expensive. Although costs can vary by lender and state, be prepared to pay anywhere from 3%–6% of the outstanding principal in refinancing fees, which can include application, origination, appraisal, and inspection fees and closing costs. With large loans like home loans, closing costs can add up to thousands of dollars.
- 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 may be offset by the higher lifetime cost of borrowing.
- Lost benefits: 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, offering deferment or forbearance plans that grant you a temporary reprieve from making payments. 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 in the near future—even though you might temporarily get a lower rate with a variable-rate loan.
Upfront or closing costs might be too high to make refinancing worthwhile, and sometimes the benefits of a current loan will outweigh the savings associated with refinancing.
When It Makes Sense to Refinance
The potential drawbacks aside, in at least a few instances, it's worthwhile to consider refinancing a loan.
You'll come out ahead financially. Do a break-even calculation to determine how long it will take for the savings from refinancing to exceed the associated costs. What some homeowners fail to consider when refinancing is that it could take a long time to recover the costs, and they may not be prepared to live in the property long enough to reap the savings.
You've improved your 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, got divorced, had a medical emergency that left you buried in debt, or even filed for bankruptcy. Regardless of the reason, if you had to get a loan when your credit score was low, your interest rate will reflect that. Refinancing when your credit score is still low won't help your finances. But once you've improved your credit score, you likely can refinance those loans at a lower rate.
You want a home renovation/addition. 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 renovate the property with a swimming room, an extra room, or another addition. Assuming your credit is healthy, you can do a cash-out refinancing to trade the equity in your home for cash.
Let's say that 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 since paid another $50,000 toward the principal. You now owe $150,000 on a home with a market value of twice that amount. If you need $25,000 for home repairs, you could refinance your mortgage for $175,000. The $150,000 that you owe on the current mortgage would be paid off, the extra $25,000 would be paid to you, and you'd have a new loan payoff amount of $175,000. Depending on available interest rates and the loan term, you may even be able to lower your monthly payments.
How to Refinance a Loan
Refinancing is like shopping for any loan or mortgage. First, take care of any issues with your credit so that your credit score is as high as possible and you qualify for the lowest interest rates. Have a rough idea of the rates and other terms you desire in your new loan. Remember: These terms should represent an improvement on the terms of your existing loan. It's helpful to do a quick loan amortization to see how your interest costs would change with different loans.
Next, shop around to find a qualified lender with the best terms. Don't just choose your current lender; get at least three or four quotes from competitors before inquiring with your current lender about what it is willing to offer. If your current lender wants to keep your mortgage, you might be able to get even better terms.
Don't open any new credit during the refinancing process; it could hinder the deal. Before signing the deal, carefully review the new loan terms and all associated fees so that you know what to expect financially when it's time to make payments.
Experian. "How Does Refinancing a Mortgage Work?" Accessed Feb. 17, 2020.
Santa Clara Federal Credit Union. "What Is Refinancing and How Does It Benefit Me?" Accessed Feb. 17, 2020.
Discover Bank. "Should You Refinance Student Loans With a Mortgage?" Accessed Feb. 17, 2020.
Board of Governors of the Federal Reserve System. "A Consumer's Guide to Mortgage Refinancings." Accessed Feb. 17, 2020.
Federal Trade Commission Consumer Information. "Using Your Home as Collateral." Accessed Feb. 17, 2020.
USAA. "Car Loans: What You Need to Know About Car Loans." Accessed Feb. 17, 2020.
National Credit Union Administration. "Personal Loans: Secured vs. Unsecured." Accessed Feb. 17, 2020.
U.S. Department of the Treasury and Peking University. "Non-Recourse Mortgage Law and Housing Speculation," Page 2. Accessed Feb. 17, 2020.
Internal Revenue Service. "Recourse vs. Nonrecourse Debt." Accessed Feb. 17, 2020.
Consumer Financial Protection Bureau. "Should I Consolidate My Private Student Loans?" Accessed Feb. 17, 2020.
Bank of America. "Refinancing to a Fixed-Rate Mortgage." Accessed Feb. 17, 2020.
Chase. "Reasons to Refinance: Lower Monthly Payments or Pay Off Your Home Sooner." Accessed Feb. 17, 2020.
Consumer Financial Protection Bureau (CFPB). "What Is a Balloon Payment? When Is One Allowed?" Accessed Feb. 17, 2020.
Federal Student Aid Office of the U.S. Department of Education. "Student Loan Forbearance Allows You to Temporarily Stop Making Payments." Accessed Feb. 17, 2020.
Federal Student Aid Office of the U.S. Department of Education. "Student Loan Deferment Allows You to Temporarily Stop Making Payments." Accessed Feb. 17, 2020.
Consumer Financial Protection Bureau. "Should I Consolidate or Refinance My Student Loans?" Accessed Feb. 17, 2020.
Chase. "Reasons to Refinance: Use Your Home's Equity to Take Cash Out." Accessed Feb. 17, 2020.
Experian. "7 Steps to Refinancing Your Home Mortgage." Accessed Feb. 17, 2020.