Loan Refinancing Explained

For most of us, debt is part of adulting. We pick up debt for many reasons, and at many different levels of cost. It’s normal to want to know more about refinancing strategies that could help you improve your overall debt situation. 

As a professional debt settlement company and experts on debt, we know that the more we share about financial solutions, the better off our readers will be. That’s why we’re breaking down loan refinancing in case it could truly benefit someone in your situation. 

No matter what you decide, remember that every step you take to understand your choices brings you closer to a better financial future.

What Is Refinancing? 

Taking out a loan means agreeing to repay the amount you borrow, plus interest and fees, over a specified period. When you refinance a loan, you take out an entirely new loan to pay off a previous loan. Typically, the new loan has better terms that could help you save money, pay off the loan sooner, or both. This is the reason why refinancing is such a popular option among borrowers.

Whether you have a home loan, student loan, or other debts that you'd like to consolidate, refinancing could help you optimize your debts. But refinancing isn’t always a good idea. Here’s what you need to know.

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Types of Refinancing Options for Debt Relief

If you're exploring your refinancing options for debt relief, you have several worth considering. They include:

Rate-and-term refinance

A rate-and-term refinance is typically associated with mortgage refinancing, which allows you to replace your current loan with one that has more favorable terms. For example, you could refinance to a lower interest rate, longer term, or both. 

When you refinance, your previous debt is paid off and you take on a brand-new loan. Rate-and-term refinancing may help ease your financial burden. Here are some of the different parts of the big picture:

• Closing costs. Even if you snag a lower monthly payment, most people spend months or years recouping what they spent on closing costs. For example, let’s say you lower your interest rate and get a monthly payment that’s $100 lower. If the lender charged you a $5,000 origination fee, you’d break even after 50 months. In other words, you’d need to save $100 per month for 50 months to recover what you spent to get the loan.

• Interest. Extending your loan term typically increases the total amount you spend on interest. But you don’t have to extend your loan term when you refinance. If you have 19 years remaining on your mortgage, you could refinance to a new 19 year loan. If you take a new 30-year loan, even at a lower interest rate, you’ll probably spend more on interest overall.

• Credit score. Interest rate requirements vary by lender. Most require a minimum credit score of 620 for loan approval. You can get a mortgage with a lower score, but it might not be at an interest rate that makes refinancing worthwhile.

Cash-out refinance mortgage

If you're refinancing a mortgage, one option is a cash-out refinance, often referred to as a cash-out refi. With a cash-out refinance, you borrow more than your current mortgage balance and receive the difference in cash. 

Basically, you borrow against the equity in your home. For example, if you have a mortgage balance of $100,000 and the house is valued at $300,000, you have $200,000 in equity. You could apply to borrow a portion of that equity. (Most home equity lenders don’t allow you to borrow 100% of your home’s value.)

Because a cash-out refinance leaves you with a larger loan balance and a smaller cushion of home equity, lenders view it as a riskier proposition than a rate-and-term refinance. That means you might need a higher credit score to qualify for a loan that puts cash in your hands.

Personal loan refinancing for debt consolidation

Personal loans are available through banks, credit unions, and online lenders, and could be used to consolidate or refinance existing debt. Most personal loans are unsecured, meaning you don't have to provide anything of value as a guarantee against the loan. 

When you use a personal loan to consolidate debt, the money comes to you as a lump sum payment, and you could use those funds to pay off existing outstanding debt. You then make monthly payments on the loan until it's repaid. If you’re consolidating debt, some personal loan lenders will send the loan funds to your other creditors directly.

Millions of people have successfully escaped high-interest debt by using a personal loan to pay it off, but the method has some risks. For example, it's possible to pay off existing debt, only to run it up again while still paying off the personal loan. If you routinely use credit cards to pay expenses, you might run up the balances again and find yourself in even more debt. 

Before taking out a personal loan to pay off other debts, make sure you have a plan to avoid creating new debt. 

Balance transfer credit cards

Anyone—including those with high credit scores—can find themselves in high-interest debt. If you're working hard to pay off debt but still have a strong credit score, you may want to consider transferring the balance to a credit card offering a 0% promotional rate. Here are a few things to keep in mind before you make the move:

• Promotional rates typically last for a short time. Once the promotional period ends, the 0% rate disappears, and you're faced with paying the standard rate, which could easily be in the high 20s. 

• The amount available may be too low. For example, if you carry $15,000 in high-interest debt, but the most you can transfer is $7,500, you still have another $7,500 to pay off and you haven’t reduced your monthly debt payments down to one.  

• A strong credit score is required. Excellent promotional rates are generally reserved for those with high credit scores. If this doesn't describe you at the moment, it won't be an option. 

• Transferring a balance isn’t free. You’ll pay a fee for the transfer, typically 3% to 5% of the amount you transfer to the new card. 

More About Refinancing

Here's how we answer some of the frequently-asked questions about debt refinancing.

What kinds of debt can I refinance? 

You can refinance almost any type of loan, including car loans, home loans, student loans, personal loans, and even credit card debt. While refinancing could change the terms of your loan, one thing stays the same: You still owe the debt, and that debt won't go away until you pay off your new loan.

Can I borrow extra while I'm refinancing? 

In some cases, you can refinance your loan and borrow extra money at the same time. Refinancing a mortgage is a great example. 

A cash-out mortgage refinance is a new mortgage that’s bigger than your old mortgage. You use the new loan to pay off the old mortgage, and you get the difference in cash that you could spend. This means you’ll have extra funds to consolidate debt, make home improvements or repairs, or reach another financial goal.

Are there any risks associated with cash-out refinancing?

A cash-out refinance is a secured debt. It’s guaranteed by the home. If you fail to repay the loan, the lender could sell the home to recover its losses. 

The risk of secured loans is that you could lose the asset if you don’t repay the loan. Why does anyone want a secured loan? Secured loans are typically the cheapest way to borrow. That asset is a financial safety net for the lender. In other words, there's less risk to the lender of losing money. 

For unsecured debts like personal loans and credit cards, there's no financial safety net for the lender, so they charge more for the loan. 

Before you decide whether refinancing is right for you, consider both the pros and cons. 

Pros and Cons of Refinancing to Pay Off Debt

The decision to refinance is highly personal, and its success depends on your individual financial situation. It’s easy to pencil out whether refinancing is more likely to benefit you or leave you wishing you'd made a different decision. 

Refinancing could allow you to save money on interest if you borrow at a lower rate and keep making the same monthly payment. Or you could save money in your monthly budget if you get a lower mortgage payment, freeing up cash for other purposes. It may also simplify your life by reducing the number of bills you pay each month 

As effective as refinancing can be, the cons sometimes outweigh the pros. For example, a lender may offer to extend the terms of your loan in order to get your payment down. That sounds great, but it also means extending the time you're responsible for paying the debt and may increase the amount you pay in interest over time.

Refinancing typically carries fees. Depending on your situation, the amount you spend on loan fees may cost you more than simply sticking with your current debts (and finding another way to pay them off). Finally, if you accumulate new debt while paying off the amount you've refinanced, you could find yourself in an even tougher financial situation. 

Pros of Refinancing

It takes time and money to refinance, but several big benefits could make the process worthwhile.

Save money on interest

The most significant benefit of refinancing is that you could save money. If you refinance at a lower rate but you keep making the same payments, you’ll pay off the loan sooner and pay less interest overall. 

Reduce your monthly payment

Another reason to refinance is to lower your monthly payment. You could get a lower payment if you qualify for a lower interest rate and/or opt for a longer loan term. Imagine you have a five-year personal loan for $10,000 with an APR of 19%. Your monthly payment is $259. 

A year and a half into the loan, you decide to refinance the remaining $8,000 balance, and you qualify for a new five-year loan with an APR of 12%. Instead of $259, your monthly payment drops to $178. 

Even with a five-year term on the new loan, you’d pay a little less interest overall because of the lower rate. 

Pay off your loan faster

You may be able to secure a lower interest rate and also shorten the length of your loan. While your monthly payments may be the same or larger, it’s possible to pay off the loan sooner and clear the debt faster.

In the personal loan scenario above, your monthly payment dropped by $81 per month after refinancing. If your goal is to pay the debt off faster, you could pay that $81 toward your monthly payment, and instead of taking five years (60 months) to pay it off, you'd pay the new loan off in three years and two months (38 months). You’d pay less in overall interest charges.

Consolidate debt

If you want to simplify your debt payments, refinancing could be a smart way to reduce the number of bills you pay. Debt consolidation means taking a new loan and using it to pay off multiple smaller debts. It could make sense if the new loan gets you a lower interest rate compared to what you currently pay.

Replace a variable rate with a fixed rate

If you have credit card debt or other variable-rate debt, you're never sure whether the interest rate will rise or fall, making it difficult to accurately budget the monthly expense. When you refinance, you can apply for a fixed-rate loan. On a fixed-rate loan, you'll always know how much your monthly payments will be. 

Simplify finances with one payment

Life gets busy, and it can be hard to make sure all your monthly payments have been made. Let's say you usually make monthly payments on three credit cards, a loan from a furniture store, and a personal loan. Refinancing those debts by debt consolidation means making a single monthly payment to the lender rather than five separate payments. Reducing the number of payments you have to make could simplify your financial life and help you avoid accidentally missing a payment. 

Cons of Refinancing

Refinancing has its benefits, but it isn’t always the right solution. You’ll need to weigh your options carefully because refinancing has some drawbacks to think about.

Transaction costs

Refinancing can be expensive. In some cases, the refinancing costs could even outweigh the benefits. There could be closing costs, origination fees, and other processing fees. Do the math, including all fees, to decide if refinancing makes financial sense.

Imagine the total cost to refinance your mortgage is $10,000, but your monthly mortgage payment drops by $100. Saving $100 monthly means it will take you 100 months (eight years, four months) to recoup the money spent to refinance. Let's say you sell your house five years after you refinanced. You might have spent less money by sticking with your original loan. 

Higher interest costs

If you refinance and take longer to pay back the debt, you could end up paying 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 more over the life of the loan.

Longer time in debt

Some lenders may offer to decrease your payments by extending the length of your loan, but a longer term means remaining in debt for longer. Ideally, refinancing should make your debt more efficient and manageable, not more expensive or more of a burden.

The decision to refinance comes down to your situation and how much you’re currently paying for your loan.

Risk of accumulating more debt

It's a great feeling to refinance debt when you have a solid plan in place to pay it off. Where you can get in trouble, though, is racking up new debt while paying off the old. Let's say you've consolidated the balances owed on five credit cards. An emergency arises, like a hot water tank leak.

Unless you have an emergency fund to draw from, you could find yourself putting the new expense on one of the cards you just paid off with loan funds. That could leave you in more debt than you started with.

Loss of federal student loan benefits

If you have federal student loans, you probably get occasional ads encouraging you to refinance. Even if the advertised interest rate is lower, refinancing federal student loans with a private lender means the loss of benefits that are only available on federal student loans. 

For example, you’ll give up access to flexible income-based repayment options, and you'll lose the deferment and forbearance options available to federal student loan borrowers. You'll no longer have access to loan forgiveness through programs such as Public Service Loan Forgiveness (PSLF). 

Impact on credit from hard inquiries

Each time you apply for a loan and a lender checks your credit report, it's recorded as a hard inquiry. Each hard inquiry has the potential to knock a few points off your credit score. For a strong credit standing, the goal is to limit the number of hard inquiries on your report. 

Your best bet is to spend no more than 14 days shopping for a single loan type. For example, shopping for a mortgage loan and an auto loan would count as two separate hard inquiries. But checking your rate with 99 mortgage lenders within a two-week span would count as only one inquiry where your credit score is concerned. Some types of credit scores allow 45 days to rate shop, but since you won’t know which credit score a lender will use, stick to a 14-day shopping window.

Prepayment penalties on existing loans

Some of your existing loans may include prepayment penalties to discourage borrowers from paying them off early. Before refinancing a debt of any type, check your paperwork to learn if there's a prepayment penalty. If you're not sure where the paperwork is, call the lender to ask. It's essential to know all the expenses involved in refinancing before deciding to move forward. 

When Refinancing May Not Be the Best Option

Refinancing may have perks, but it's not always the best option. Here are five situations when refinancing may not be your best strategy. 

Transaction costs outweigh savings

First, list all the costs involved. Note closing costs, administrative fees, prepayment penalties, and any other expenses related to the new loan. The money you spend to secure the loan could be greater than the amount you could save. 

You're struggling to make payments

If you're struggling to make monthly payments, you may want to think twice about applying for a refinance loan. If you currently have more debt than you can reasonably afford, your debt-to-income (DTI) ratio may be too high for a lender to approve your application. Other debt relief options might be a better fit. For example, debt settlement, where your lender accepts less than the full amount you owe and forgives the rest, or a debt management plan (DMP), a structured repayment plan through a credit counselor.

You don't qualify for better rates

If you aim to lower monthly payments, pay debts off faster, or both, a low credit score could stand in your way. The lowest interest rates and loan terms are generally reserved for those with strong credit scores. It might be worthwhile, financially, to find out what’s holding down your score so you can work on that factor and bring your score up. 

Remember: There's no shame in dealing with credit issues; millions of people have been able to turn credit problems around.

You're close to paying off a debt

If you're getting close to paying off debt, keep going. Unless you've run into a situation that makes it challenging to make payments, there may not be a reason to take on the expenses associated with refinancing when the end is in sight. 

When money habits caused the debt 

There are many ways to find yourself in debt. For example, a job loss or unexpected illness can cause bills to pile up. However, everyday money habits can also lead to debt. If you have trouble passing up a night out with friends even when money’s tight, or find it nearly impossible to say no to your children when they ask for something, you could find yourself in debt. 

Refinancing can’t fix money problems. It could, however, be part of a larger strategy to learn how to manage your money better. It's possible to swap a spending habit for a savings habit, but it takes time and practice. Before signing on to refinance a loan, make sure your money habits won't lure you back into debt. 

Another solution when refinancing isn’t the right path

Perhaps the most frustrating thing about debt is how it can make you feel. Whether the debt came from issues outside your control or you've made a few missteps, you deserve to know what life feels like without debt hanging around. 

Debt settlement is a process in which you, or a debt relief program working on your behalf, negotiates with your creditors to accept less than the full amount you owe and forgive the rest. If you're facing significant financial hardship, debt settlement is one way to get control of unsecured debts, like personal loans and credit card balances. 

When to Refinance

In general, if you can save money on your existing loan, refinancing could make financial sense. Here are two situations when refinancing might be the best option.

Rates are low

If interest rates fall, you might save money if you can lower the interest rate on your existing debt. One rule of thumb: It might make sense to refinance if rates are 2% or more below your current rate. 

Your credit has improved

Your credit score plays a huge role in determining your interest rate. Generally speaking, the higher your credit score is, the lower the interest rate you’ll receive. If you’re keeping up with payments on your current loan and your credit score has improved, you might qualify for a better rate and more favorable terms.

Refinancing could be a smart choice if you can save money or if your circumstances have changed and better rates are available. 

Refinancing vs. Debt Settlement: Which Is Right for You?

Choosing refinancing or debt settlement depends on your current financial situation. Refinancing is for someone who qualifies for a better deal on their debt. Settlement is for someone who has a hardship and can’t afford their debt. Here’s a look at the differences between refinancing and debt settlement to help you figure out which option fits most comfortably into your life. 

How to Refinance

Here are the steps you’ll take to get started with a loan refinance. 

1. Check your credit

Your first step is to check your credit report by ordering free copies from the three major credit reporting agencies: Experian, Equifax, and TransUnion. Free copies are available every week through annualcreditreport.com. Go over each report carefully, looking for any errors that might drag your score down. For example, if one of the reports shows a balance on a credit card you've already paid off, make a note of it.

If you find a mistake, report it to the credit bureau in question. The easiest way is to dispute it while viewing your credit report online. In some cases, you may need to provide additional documentation by mail. By law, credit bureaus have 30 to 45 days to investigate your claim. If you're correct and there's a mistake on your report, it must be removed. 

The condition of your credit should give you an idea of whether you'll be eligible for a refinance loan. 

Use a free credit score website to check your score. Your bank or credit card issuer might offer free credit scores. When you view your score, you’ll usually also receive information about what factors are affecting it. Those are the items to work on if you want to improve your score.

2. Review your loan options

Once you know the condition of your credit report, check out local and online lenders. Some lenders conduct a soft credit check first to let you know what you might qualify for. When you’re prequalified, it means that if the basic information you provided doesn’t change significantly, you might qualify for a loan when you apply. The lender gives their best guess, but can’t guarantee approval until you formally apply and an underwriter has the chance to review your details.

Once you prequalify, a lender will fill you in on the details of the loan. In addition to the interest rate, the lender will lay out possible loan terms, and the total amount you might pay in interest and fees. 

Comparing rates, terms, and total loan costs from multiple lenders could help you make a more informed decision on which loan is best. 

3. Make sure the new loan aligns with your financial goals

After you compare offers, you may discover that one loan makes more sense than another based on your circumstances. The new loan should be one that you can afford to pay each month, helps you save money now or over time, and allows you to reach your goals.

Before making a final decision, compare all loan offers. Factor in all fees associated with the loan and weigh that amount against how much you'll save by refinancing. Evaluate whether your financial life will improve by taking the loan.

4. Take the next step

Once you've chosen a lender, gather the documents you may be asked to provide. The documents you'll need will depend on what kind of loan you’re refinancing. Generally, here's what you'll need:

• Pay stubs

• W-2 or 1099s

• Bank statements

• List of debts

• Personal identification

You may also be asked to provide:

• Last two mortgage statements

• Your most recent tax returns

• Insurance information

• Investment account statements

Refinancing: Yes or No?

In many cases, refinancing aims to get a lower interest rate and save money over the life of the loan. It could also help relieve some of your financial stress by lowering your monthly payments and giving you more time to repay the loan. 

Everyone’s situation is unique. Review your goals and make sure the loan you're considering will help you achieve them. Then, look for the right lender, one with rates and terms that fit your needs.