What is Replacement Debt Financing?

What is Replacement Debt Financing?

Tammi Huang

March 19, 2019

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 with better terms that could help you save money, pay off the loan sooner, or both. This is the reason why replacement debt refinancing is such a popular option among borrowers.

Whether you have a home loan, student loan, or other debts, refinancing could enable you to shift your debts to a more favorable position. But before you take action, you need to understand the pros and cons of refinancing.

What is refinancing a loan?

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.

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 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.

Cash-out refinance

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.

Cash-in refinance

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

It takes time and money to refinance, but there are several big benefits that could make it worthwhile:

  • Save money on interest. 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. 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. While your monthly payments may increase, you could pay off the loan sooner and be free of the debt faster.

  • Consolidate debt. 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.

Risks 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.

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, 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.

When to refinance

If 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.

  1. 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.

  2. 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.

  3. 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.

  4. 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.

Take action today and turn the corner on your debt

Replacement debt financing is one of several options for getting a handle on your debt. If you’re struggling with debt, Freedom Debt Relief can help you understand your options, including our debt settlement program. Our Certified Debt Consultants can help you find a solution that will put you on the path to a better financial future. Find out if you qualify right now.

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