Refinancing is the process of paying off an old loan with a new loan. Depending on the terms of the new loan, refinancing could help you:
- Lower your monthly payment
- Lengthen or shorten your repayment period
- Change your payment structure
You can refinance almost any type of loan, including car loans, home loans, student loans, personal loans, and even credit card debt. While replacement debt refinancing could change the terms of your loan, you’ll still owe the balance of your original loan, and that debt will not go away until you pay off your new loan.
Types of refinance loans
The type of loan that’s best for you will depend on your situation and goals. Secured loans typically have lower rates because the lender can repossess your asset (such as your home) if you do not pay. Other options like personal loans are unsecured, which means they aren’t tied to your assets. For unsecured loans, your creditworthiness, FICO score, and other factors determine your interest rate.
It’s important to understand your best options before you jump into replacement debt financing.
This type of loan is also known as a traditional refinance and is arguably the most straightforward. Other than the costs associated with the refinance, no money actually changes hands and the size of the loan remains the same. You just change your current interest or loan terms for different ones.
If interest rates are low, you could refinance an adjustable-rate loan into a fixed-rate loan to lock in a lower rate for a specified period of time. You could also refinance to a shorter loan term, save money on interest, and pay off your debt sooner.
One common reason for refinancing is to tap into your home equity, providing cash for other uses, such as paying off another debt or funding a home improvement project. The downside is that your mortgage balance will increase when you refinance.
Remember, a cash-out refinance is a secured loan backed by your home. If you fail to repay your loan, you risk losing your property as well.
The opposite of a cash-out refinance is a cash-in refinance, in which you pay down your balance to qualify for a lower interest rate. Bringing in cash will also lower your loan amount, reducing your monthly payment and the amount of interest you’ll pay throughout the life of the loan.
One of the most common reasons borrowers choose to do a cash-in refinance is because they owe more than their home is worth. They would first need to pay down their mortgage balance to a suitable loan-to-value ratio in order to qualify for a refinance.
Benefits of replacement debt refinancing
While there are some notable benefits, refinancing isn’t always the right solution. You’ll need to weigh your options carefully, because refinancing has its share of drawbacks as well.
Choosing a loan isn’t just about the interest rate or the monthly payment. There are many costs associated with refinancing, and it could end up being really expensive. In some cases, the refinancing costs could even outweigh the benefits.
- Origination fees. Many lenders charge an upfront origination fee to process your loan application, which cover the costs of underwriting and verifying you as a borrower. They’re based on your credit score and the length of your loan.
- Processing fees. Depending on your lender, you may have to pay application fees, check processing fees, late payment fees, prepayment penalties, and more. Lenders are required to disclose associated loan fees.
- Interest costs. If you refinance and lengthen the term of your loan, you may pay more in interest over time. When you spread out your payments over a longer period (even at a lower interest rate), the monthly payments could be lower, but the interest could add up to even more over the life of the loan.
- Closing costs. If you’re refinancing your home, you’ll also have to pay closing costs to cover the services and expenses required to finalize your loan. The amount varies by lender, loan type, and the cost of fees in your area. Your credit score and how much equity you have in your home also will determine your total closing costs.
All loans come with interest and fees—consider them the cost of borrowing money. These costs can quickly add up, so it’s very important to do the math ahead of time to see if it makes financial sense to go through with a refinance.
Longer time in debt
Some lenders will offer to decrease your payments by extending the length of your loan, but a longer term means more money spent on interest payments. Ideally, refinancing should not only reduce your monthly payments but also the time it will take you to repay the loan.
Risks of replacement debt refinancing
If you own your home, a cash-out refinance lets you replace your existing mortgage with a new one with a higher balance. You use the new, higher mortgage to you pay off your previous lower balance mortgage and keep the cash difference between these two loans. Then you use that cash to pay off your debts. Essentially, a cash-out refinance is a strategy that could allow you to cash out on some of your home equity at a relatively low interest rate and apply it toward your high-interest debt. Sometimes, you could even lock in a lower interest rate than your original mortgage loan.
Keep in mind that if you go this route, you’ll need to pay the various costs associated with refinancing. These include home appraisal expenses, closing costs, and other fees, which may add up to thousands of dollars. So before pursuing ta cash-out refinance, do the math and make sure the fees still make it worth it.
If you have high-interest credit card debt, debts from personal loans, student loan, or auto loans, and are confident you’ll be able to make your payments, this may be a good option. However, if you are not a homeowner and/or are worried you won’t be able to make your payments on time and do not want to risk foreclosure, a cash-out refinance probably isn’t right for you.
When to refinance
f you can save money on your existing loan, then replacement debt refinancing could make financial sense. Here are two situations when refinancing could be a great option to explore:
- When rates are low. Some experts say to refinance if rates are 2% or more below your current rate. But each borrower’s situation and financial goals are different. You’ll need to consider all your associated costs and determine if a new loan will truly save you money.
- When your credit has improved. If you’re keeping up with payments on your current loan and your credit score has improved, you’ll likely be offered a better rate and qualify for more favorable terms on a new loan.
How to refinance
Once you decide that replacement debt refinancing is the way to go, you’ll want to take the following steps to get the best loan possible.
- Review your loan options. Comparing rates and terms from multiple lenders will help you find the best possible interest rate and fees, and help you make a more informed decision on your refinance.
- Calculate your all-in costs. Don’t put all your focus on interest rates alone. Make sure to also look at the annual percentage rate (APR), which tells you the true cost of your loan by including fees and interest.
- Make sure the new loan aligns with your financial goals. The new loan should be one that you can afford to pay each month, helps you save money over time, and allows you to achieve your goals faster.
- Lock in your rate. If you find that the savings on the new loan is worth the up-front investment, refinancing may be the right choice for you. Move forward with the lender by locking in your new rate and start the refinancing process.
In many cases, the goal of refinancing is to get a lower interest rate and save money over the life of the loan. But it could also help take away some of your financial stress by lowering your monthly payments and giving you more time to pay back the loan. Everyone’s situation is unique, so take the time to review your goals and make sure that the loan you are considering could actually help you achieve it. Then, make sure you find the right lender, with rates and terms that fit you.
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