Americans are struggling to keep up with their debt repayments more than ever. The number of households having missed loan payments for 90+ days on some loans is at 14-year highs. If you’re having trouble paying your loans on time, one possible solution is loan refinancing. But a refinance isn’t the answer for everyone’s situation.
What Does It Mean to Refinance a Loan?
When you refinance a loan, you’re essentially starting a new loan with new terms.
You replace your existing loan by using the new loan’s money to pay off the old loan.
Refinancing usually means switching lenders, although your existing lender might allow you to refinance with them.
Typically, people refinance because they want to change their loan terms with a new interest rate or a lower monthly payment amount.
What are the Benefits of Refinancing?
Depending on your situation, there may be some significant benefits to refinancing:
- Lower Monthly Payment: If you’re struggling to make your payments, you may refinance to get a lower loan payment. This can be done by extending your loan term. Of course, you should know that doing so will mean you pay more interest overall. You can also achieve a lower monthly payment if you get a lower interest rate on your loan.
- Better Interest Rate: If interest rates have significantly dropped since you initially took out your loan, you may want to refinance to take advantage of a better rate. If your loan is large, a lower interest rate can save you hundreds or thousands of dollars over its term.
- Better Credit Score: Similarly, if your credit score has increased significantly, you may now qualify for a better interest rate.
- Consolidate Debt: Some people refinance several small loans into one large consolidated loan. The benefit of consolidating your loan is that you’ll only have one payment to consider, and you can more clearly see your progress and debt repayment timeline.
- Changing Loan Type: If your loan has an adjustable rate, and you want to switch it to a fixed-rate mortgage—or vice versa—you’ll need to refinance it.
- Accessing Home Equity: You can refinance to borrow against the equity in your property, which gives you access to extra funds. This is known as a cash-out refinance.
- Eliminate PMI: If your property’s value has significantly increased, you might have enough equity to refinance and get rid of your private mortgage insurance (PMI). This can help you save a significant amount on your overall mortgage loan.
What are the Drawbacks of Refinancing?
Refinancing does come with some potential downsides you should be aware of, including:
- Additional Costs: Refinancing is never free; it can be quite costly. For example, mortgage refinancing usually costs between 2% and 6% of the loan amount. On a $400,000 mortgage, you’ll likely pay between $8,000 and $32,000. You’ll be paying various fees, including property appraisal, title search, and legal fees.
- More Interest: If you’re refinancing to a longer long term to have lower monthly payments, you’ll pay more interest overall on your loan.
- Credit Score Decrease: Since this is a new loan application, refinancing your loan will require a hard inquiry into your credit. Hard inquiries cause a small, temporary dip in your credit score.
- Prepayment Penalties: Sometimes, refinancing means you’ll incur a prepayment penalty with your previous lender.
- Interest Rate Decreases: Refinancing is costly and takes up some of your time. There’s always a risk that your timing isn’t right. Interest rates could decrease further, and you wish you had waited to refinance.
How to Know if Refinancing Is Right for You
Refinancing is often a good option, but you must time it right. You should only pursue a refinance when the benefits outweigh the costs.
Here are a few situations in which it’s likely best to refinance:
- You’re behind on payments. You desperately need a lower monthly payment; otherwise, you’ll become delinquent on your loan. Refinancing can be an excellent solution for a more affordable payment. If you don’t qualify for a lower interest rate, you can extend the loan term. Just make sure you have a way to pay for all the costs associated with the refinance.
- You’ll save more than you spend. As mentioned above, refinancing comes with some costs. However, if you’ve done the math and the money you’ll save outweighs the costs, go with the refinance.
- Your credit has improved. If your credit score has majorly improved since you first took out your loan, refinancing will get you a lower interest rate. A reduced rate means a lower monthly payment and less interest paid over the life of the loan.
- You have lots of outstanding debts, and you can’t keep up. If you have several debts with many creditors, consolidating everything into a singular, refinanced loan can be beneficial. You’ll only deal with one payment, so you can ensure you never miss it. And your singular loan may have a lower interest than all your other loans.
- You have credit card or high-interest debt. Credit cards typically have incredibly high interest rates. In this case, it may be beneficial to refinance to a personal loan with a lower interest rate.
- You need to change your mortgage to adjustable or fixed. In this case, make sure you’ve considered the costs associated with refinancing.
- You need to access equity or get rid of PMI. Good reasons to refinance a mortgage are to get rid of PMI or to access equity to pay for an upcoming large expense.
So, when is it not worth refinancing? Don’t bother if the interest decrease is small or you think you’ll pay off your loan soon anyway.
You always want to get rid of your debt as soon as possible. So, only refinance if the costs are justified will help you become debt-free sooner or more financially secure right now.
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