Learn About Refinancing: Pros and Cons of Replacing a Loan
What is Refinancing?
If you have a loan that’s too expensive or too risky to live with, you can often refinance into a better loan. Things may have changed since you borrowed money, and there may be several ways to improve the terms of your loan. 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 is the process of replacing an existing loan with a new loan.
The new loan pays off the current debt, so that debt is not eliminated when you refinance. However, 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 that 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.
Why People and Businesses Refinance
Refinancing is time-consuming, it can be expensive, and a new loan might be missing attractive features that an existing loan offers. So why go through the process? There are several potential benefits to refinancing.
Save money: 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 interest rate.
Especially with long-term loans and large dollar amounts, lowering the interest rate can result in significant lifetime interest savings.
Lower payments: 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 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.
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 monthly flow, see how to calculate loan payments.
Shorten the loan term: Instead of extending repayment, you can also 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 move might make sense if you want to make larger payments to get rid of the debt more quickly. Of course, you can also just make extra payments without refinancing. Making larger payments without refinancing would help you avoid paying closing costs and keep some flexibility (you can pay more than the minimum, but you don’t have to if something comes up).
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, but consolidating can cause problems (see below).
Change your loan type: Even if you don’t lower your 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 switch to a loan with a fixed rate. A fixed interest rate could offer 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 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.
Disadvantages of Refinancing a Loan
Refinancing is not always a wise move. Even if you secure a lower interest rate or lower monthly payment, it could be a mistake to get rid of existing loans. Evaluate the pros and cons carefully 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. 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.
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. Plus, federal loans might be 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
When you refinance, some things change, and some things don’t.
Debt: Your loan balance will not change. You’ll still have the same amount—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.
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. In some cases, you can actually increase the risk to your collateral when you refinance. Some states allow non-recourse home loans to become recourse loans after refinancing.
Payments: You still have to make payments, but in most cases, your 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 free online spreadsheets).