Refinancing: Pros and Cons of Replacing a Loan

When you take out a loan, you’re agreeing to repay the amount you borrow plus interest over a specified period of time. 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. This is the reason why refinancing is such a popular option among borrowers.

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 refinancing is positive. So before you refinance one of your loans, you need to understand the pros and cons of refinancing.

What is Refinancing?

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 length, or 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 refinancing could change the terms of your loan, one thing stays the same: You still owe the balance of your original loan, and that debt will not go away until you pay off your new loan.

There are 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 enables 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 another financial goal.

ProsCons
  • High interest debts paid off

  • Reduced monthly payments

  • Tax-deductible interest payments
  • Need to own a home

  • Increased foreclosure risk

  • Adds to mortgage debt

Types of Refinance Loans

There are many kinds of loans you could refinance into, but the type 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 if you do not pay. Other refinancing options like personal loans are unsecured, which means they aren’t tied to any of your assets. For unsecured loans, your creditworthiness, FICO score, and other factors determine your interest rate.

It’s important to understand your top refinancing options before you make the decision to change your existing loan.

  • Rate-and-Term Refinance
    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. The size of the loan remains the same. You just change your current interest or loan terms for different ones.
    For instance, 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.
  • Cash-Out Refinance
    One common reason for refinancing is to tap into your home equity. With this option, the lender gives you the money that you need to put towards other uses, such as paying off another debt or funding a home improvement project. The downside is that your mortgage balance will also 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.
  • Cash-In Refinance
    The opposite of a cash-out refinance is a cash-in refinance. With this type of loan, 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. Though there are various reasons borrowers choose to do a cash-in refinance, one of the most common reasons is because they are underwater on their mortgage, or they owe more than the current value of their home. 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 Refinancing

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

  • Save Money on Interest
    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 can result in significant savings.
  • Reduce Your Monthly Payment
    Another obvious reason to refinance is to lower your monthly payment. If you are 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 big benefits to refinancing, it isn’t always the right solution. You’ll need to weigh your options carefully, because refinancing has some notable drawbacks too.

Refinancing Costs

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. These fees cover the costs of underwriting and verifying you as a borrower. The origination fees typically depend on your credit score and the length of your loan.
  • Processing Fees
    Depending on your lender, you may have to pay other fees attached to your loan, such as application fees, check processing fees, late payment fees, pre-payment penalties, and more. Lenders are required to disclose associated loan fees so make sure to take them all into account.
  • 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.
  • Closing Costs
    If you are refinancing your home, you’ll also have to pay closing costs. This fee covers the services and expenses required to finalize your home loan. The amount varies by lender, loan type, and the cost of fees in your area. Additional factors such as your credit score and how much equity you have in your home 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.

Refinancing has many pros and cons, and 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. Calculate Your All-In Costs
    When you’re looking for a loan, don’t put all your focus on interest rates alone. Make sure to look at the annual percentage rate (APR) too. The APR tells you the true cost of your loan by including fees and interest, better reflecting the full cost of the loan.
  3. 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.
  4. 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 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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