What Is Refinancing?
- Debt refinancing means paying off an old loan with a new loan with better terms.
- Refinancing to a lower rate can free up cash to pay your debt down faster.
- Most people refinance to get a lower interest rate, a lower payment, or both.
Refinancing a debt simply means using a new loan to pay off an old one. The refinance loan should deliver some benefit, like a lower interest rate, a smaller payment, a fixed interest rate, or cash out.
When Does Refinancing Make Sense?
Refinancing is just trading one form of debt for another. So what’s the point in doing that?
There are a few benefits that are possible from changing the nature of your debt. It can make sense to refinance debt if the refinance loan provides any of the following:
Lowering your interest rate
Lowering monthly payments by spreading them over a longer time
Reducing total interest cost by paying debt off faster
Stabilizing debt by switching from a variable to a fixed-rate loan
Making debt more manageable by consolidating multiple balances into one refinance loan
Cashing out home equity to cover an immediate financial need
Some of these goals have the immediate benefit of lowering your monthly payment. The value of this benefit may seem obvious -- you can see it by simply comparing your current monthly payment with the payment you’d get if you refinanced.
However, if you lower a monthly payment by shifting to a loan that takes longer to repay, you will likely pay more interest in the long run. Compare the total costs of both your current debt and a potential refinance loan. Weigh any long-term cost difference against the short-term benefit of lowering your monthly payments.
Sometimes, refinancing works the other way around. You may incur higher near-term expenses in exchange for lowering the long-term cost of the loan. This can happen if you refinance to a shorter-term loan. It can also occur when there are upfront fees for refinancing.
What Is Refinance Breakeven?
Suppose you want to figure out whether higher upfront costs are worth the long-term benefit of refinancing. In that case, you need to figure out your refinance breakeven point.
For example, if you owe $1,000 on a credit card balance and it costs $30 to pay it off (refinance) with a zero-interest balance transfer card, how long does it take you to save $30 in interest with the new card? That’s your breakeven point.
Knowing that breakeven point can help you decide whether refinancing is worthwhile in your situation.
What Kind of Debt Can You Refinance?
Debt comes in many different forms. You may have student loans, car loans, balances on your credit cards, or a mortgage. You may also have taken out personal loans or even owe debt on short-term payday loans.
Potentially, any one of these forms of debt can be refinanced. The key is whether you can replace it with another form of debt that delivers one or more of the benefits listed in the previous section of this article.
What Are the Types of Refinance Loans?
Since you can refinance several different types of loans, what type of refinance loan can you use to replace your old debt? Can you pay off one kind of debt with another type? For example, could you pay off credit card debt with a personal loan?
The answer is “yes.” You can use several types of loans to refinance old debt, and often the advantage comes from refinancing one category of debt with a different kind.
Below is a list of some common types of debt, along with the pros and cons of using each type of debt to refinance.
What it is: A mortgage is a loan secured by real estate, which makes them low-risk to lenders. That security causes mortgages to have lower interest rates than just about any other form of debt.
Pros: Refinancing can change the terms of your mortgage debt to better suit your needs. Depending on the circumstances, this can be a way of lowering your interest rate, saving on interest by repaying the loan sooner, or reducing your monthly payments by spreading them over a longer time.
Cons: Mortgage refinancing costs are higher than those of other types of loans.
What it is: Cash-out refinancing allows you to refinance with a loan that’s larger than your current mortgage and take the difference in cash.
Pros: This type of refinancing can kill two birds with one stone: it can improve the terms of your current mortgage and provide you with a relatively low-cost form of debt for other things.
Cons: Using your home to secure debt could put your home at risk if you have trouble repaying the loan. Also, the upfront costs may not be worth it unless you borrow enough to save a substantial amount of interest in the long run.
Home equity loan
What it is: This is a (usually) fixed-rate second mortgage secured by the equity in your home that delivers a lump sum of cash. It does not replace your existing mortgage but adds new debt on top of the amount you currently owe. So a home equity loan would not be used to refinance your mortgage but to refinance other debts.
Pros: If the terms of your current mortgage are good, a home equity loan offers a relatively low-cost way of borrowing cash without replacing your existing mortgage.
Cons: The new loan comes with closing costs, and your home is at risk if you can’t make the payments.
Home equity line of credit (HELOC)
What it is: HELOCs are also second mortgages, but instead of a lump sum, you get a line of credit that you can draw against as needed – like a credit card secured by your home. HELOCs can be cheap or even free to set up. HELOCs usually come with variable interest rates. HELOCs have two phases. The first is a drawing phase in which you can borrow when you want and pay only the interest charge. The next is the repayment phase, when you make payments designed to zero your balance during the remaining term of the loan.
Pros: This loan gives you on-demand access to a relatively low-cost source of credit. It can be helpful if you expect to face a series of new expenditures over time, rather than just a single expense all at once.
Cons: You need to have a repayment plan, so borrowing with your HELOC doesn’t put your house at risk. HELOC payments can rise sharply when you enter the repayment phase.
What it is: This is a (usually) fixed-rate loan you take out for personal use. It is (usually) unsecured. However, you may get better terms by pledging a personal asset as collateral.
Pros: Personal loans usually have higher interest rates than mortgages, but they do not require you to use your home to secure them. On average, interest rates on short-term personal loans run about 7% lower than those of comparable credit cards.
Cons: You need good credit to qualify for a personal loan, or else the cost might rise significantly. There are also costs associated with getting a personal loan, so they should not be used casually for small purchases.