The Pros and Cons of Loan Refinancing

The Pros and Cons of Loan Refinancing
BY Molly Zilli
Apr 9, 2019
Key Takeaways:
  • Refinancing a loan can reduce your interest rate, your payments, or both.
  • Refinancing costs money, however. Make sure the savings exceeds the cost.
  • Refinancing can extend repayment and cost more in the long run.

Whether you have a home loan, student loan, or other debts, refinancing could give you the ability to shift your debts to a more favorable position. But not everything about loan refinancing is positive. So, before you refinance any of your debt, learn more about the pros and cons involved.

What is refinancing?

When you refinance a loan, you’re getting a new loan to pay off the previous loan. Typically, the new loan has better terms that could help you save money, pay off the loan sooner, or both. For example, it could lower your monthly payment, lengthen or shorten your repayment window, or improve your interest rate.

You can refinance almost any type of loan, including car, home, personal, and student loans. Even credit card debt is eligible. Some of these options are considered secured debts because they are backed by an asset you own. If you fail to repay that secured loan, you risk forfeiting that asset. Other options like personal loans are unsecured, so they aren’t tied to any of your assets.

Secured loans typically have a lower rate because of that ability to repossess the asset if you don’t pay. For unsecured loans, your creditworthiness, FICO score, and other factors determine your interest rate.

It’s worth noting that there are also some cases where you can refinance your loan and take out more money at the same time. For example, if you’re short on cash but have equity in your home, cash-out mortgage refinancing can enable you to get a larger loan than you need to pay off the previous mortgage. This means you’ll have extra funds you can use to consolidate debt, make home improvements or repairs, or reach some other financial goal.

Why refinance?

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

  • Save money on interest

    One of the biggest benefit of refinancing is to save money on your existing loan. If you refinance to a lower rate, you could pay less interest every month and over the lifetime of your loan, which could result in significant savings.

  • Reduce your monthly payment

    Another obvious reason to refinance is to lower your monthly payment. If you’re able to lock in a lower interest rate or lengthen your loan term, it could make your payments easier to handle and free up money to go towards your savings and other expenses.

  • Pay off your loan faster

    You may be able to secure a lower interest rate and at the same time, shorten the length of your loan. While your monthly payments may increase, you could pay off the loan sooner and be free of the debt faster.

  • Consolidate debt

    If you want to simplify your debt payments, refinancing could be a smart way to combine multiple debts into one account with one lender. However, it’s important to remember that you still need to pay off the total amount that you owe. Debt consolidation simply puts you into a different type of debt.

Risks of refinancing

While there are some potential benefits to refinancing, it isn’t always the right solution. You’ll need to weigh your options carefully, because loan refinancing has some notable drawbacks too.

  • Transaction costs

    Refinancing can be really expensive. In some cases, the refinancing costs could even outweigh the benefits. There could be closing costs, origination fees, and other processing fees, so it’s important to do the math ahead of time to see if it makes financial sense to refinance.

  • Higher interest costs

    Keep in mind that if you refinance and lengthen the term of your loan, you may 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 even more over the life of the loan.

  • 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 wasted on interest payments. Ideally, refinancing should reduce your monthly payments and the time it will take you to repay the loan.

Whether or not you should refinance depends on your current situation and how much you’re paying for your loan right now.

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 could be a great option to explore.

  • When rates are low

    If interest rates fall , you may be able to save money by securing a lower rate than you have on your existing loan. But how much should rates fall before you refinance? Some experts say to refinance if rates are two percent 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

    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’ll likely be offered a better rate and qualify for more favorable terms on a new loan.

If you can save money by refinancing, or if your circumstances have changed and better rates are available, refinancing could be a smart choice. But how do you go about the refinancing process?

How to refinance

Once you decide that refinancing is the way to go, you’ll want to take the following steps to get the best loan possible.

  1. Review your loan options

    Start by shopping around and collecting quotes from local and online lenders. Comparing rates and terms from multiple lenders will help you find the best possible interest rate, lower fees, and help you make a more informed decision on your refinance.

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

    After comparison shopping, you may discover that one loan makes more sense than another based on your personal circumstances. 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.

  3. Lock in your rate

    Once you’ve identified a new loan, run the numbers and see how much you stand to save. 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 loan refinancing is to get a lower interest rate and save money over the life of the loan. For others, it relieves some financial stress by lowering their monthly payments and giving them 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 them. Then, find the right lender, with rates and terms that work for you.

Get a handle on all your finances

There’s a lot more to personal finance than simply figuring out how to pay off your debts. Luckily, learning how to deal with debt, money, and planning for your future doesn’t need to be hard. To help you along the path to a better financial future, we’ve developed a simple to follow guide with the tools you’ll need. Get started by downloading our free guide right now.