What Does It Mean to Refinance a Loan?
What Does It Mean to Refinance a Loan?
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Loan refinancing refers to the process of taking out a new loan to pay off one or more outstanding loans. Borrowers usually refinance in order to receive lower interest rates or otherwise reduce their repayment amount.
For debtors struggling to pay off their loans, refinancing can also be used to get a longer-term loan with lower monthly payments. In these cases, the total amount paid will increase, as interest will have to be paid for a longer period of time.
What does it mean to refinance a loan?
Refinancing a loan is when a borrower replaces their current debt obligation with one that has more favorable terms.
Through this process, a borrower takes out a new loan to pay off their existing debt, and the terms of the original loan are replaced with an updated agreement. This enables borrowers to redo their loan to get a lower monthly payment, a different term length or a more convenient payment structure.
Most consumer lenders that offer traditional loans also offer refinancing options. However, for products like mortgages and car loans, refinancing loans tend to come with slightly higher interest rates than purchase loans.
The primary reason borrowers refinance is to get a more affordable loan. A lot of the time, a refinance can lower the interest rate.
Borrowers also refinance their loans so that they can pay them off quicker. Although longer terms allow for a lower monthly payment, they also carry a higher overall cost because of the extra time the loan spends accruing interest.
However, some loans like mortgages and car loans will come with prepayment penalties, so the benefit of refinancing can be weakened by the cost of paying that extra charge.
How to refinance a loan
While each refinancing process will differ depending on your current lender and the lender you’re considering refinancing with, here’s a general idea of what steps to take:
- If you're looking to refinance a loan, you should first examine the specifications of your current agreement to see how much you're actually paying. Be sure to take note of your interest rate, terms and monthly payment amounts.
- You should also check if there is a prepayment penalty on your current loan, as the value of refinancing could potentially be outweighed by the early termination cost. A prepayment penalty is a fee some lenders charge in order to recoup the loss taken on interest when you repay a loan early.
- After finding the value of your current loan, you can compare a few lenders to find the terms that best fit your financial goals. Pay attention to any fees, and be sure to compare interest rates and repayment terms to your current ones.
Whether you're looking to change term lengths or lower your interest rate, a variety of loan options are available today.
With new online lenders looking to compete with traditional banks, there are services and packages tailored to all financial goals. For the most qualified borrowers, this competition can help cut the costs of a loan by hundreds or thousands.
Pros and cons of refinancing
Reasons for refinancing a loan
Refinancing a loan may sound like an attractive option for a variety of reasons, whether that be to save money or to pay off a loan amount quicker.
- Lenders may offer you lower interest rates. If your credit score has increased since your original loan, and/or market conditions now provide more favorable interest rates, you may get offers for much lower interest rates now. If so, you can save hundreds, or even thousands, of dollars over the life of your loan by refinancing.
- You’re looking for more affordable payments. If you’re finding it difficult to keep up with your current payments, it may be time to consider refinancing your debts. You can do this by lengthening the repayment term or finding lower interest rates.
- You want a shorter loan term. If you’re ready to put your loan repayment on the fast track, refinancing your current loan can help you do that if you choose to go with a shorter loan term. This move can also help you save money on interest.
- You want to convert from variable interest rates to fixed. Fixed interest rates, as the name suggests, remain the same throughout the life of a loan and don’t adjust along with the market the way variable interest rates do.
Examples of refinancing
Whether it’s a credit card or mortgage loan, many forms of credit can be refinanced into a new package that better fits your financial situation and goals.
Student loan refinancing is commonly used to consolidate multiple loans into one payment. For example, a recently graduated professional might have a package of debt that includes private loans, subsidized federal loans and unsubsidized federal loans.
Each of these loan types has a different interest rate, and the private and federal loans are likely to be serviced by two different companies — meaning that the borrower must make two separate payments each month.
By refinancing their loans and using one lender, the borrower can manage their debt through one company and possibly lower their interest rate.
To refinance a personal loan, you can take out another personal loan with better terms or even apply for a credit card, specifically one with a 0% intro annual percentage rate (APR).
In some cases, you may even be able to refinance your current personal loan with the same lender, though not all lenders are willing to do this.
When shopping around to refinance a personal loan, be sure to compare APRs, repayment terms and fees. Some lenders charge origination fees — an administrative fee that typically comes out of the balance of your loan — though there are many no-fee lenders on the market as well.
Personal loans are often used as a way to refinance credit card debt. Interest accrues rapidly on an outstanding credit card balance, and it can be hard to manage continuously growing debt.
Credit card interest rates, which are applied monthly, also tend to be higher than personal loan rates. So, by paying off the credit card balance with a personal loan, debtors are likely to get a more affordable and manageable way to pay off their debt.
The two main reasons that homeowners refinance their mortgages are to lower their monthly payments and to shorten their term length from 30 years to 15 years.
For borrowers considering a mortgage refinance, it's important to note that closing costs can be quite high, so refinancing to shorten your term length or lower your monthly payment by $100 or $200 might not be worth the time and money that goes into getting a new loan.
Alternatively, if you have a surplus of cash, some lenders will allow you to recast your home loan to adjust your monthly payments.
Types of mortgage refinance options
Here are different ways you can refinance your mortgage:
- Rate-and-term refinance: This is one of the most common forms of mortgage refinancing. Typically, it involves paying off the old lender with a new loan and refinancing with more favorable terms, such as lower interest rates or lower monthly payments.
- Cash-out refinance: This type of refinancing lets you take advantage of the equity you’ve already built. To do this, you’ll replace your current mortgage with a larger one and pocket the difference.
- Cash-in refinance: Similar to a cash-out refinance, a cash-in refinance involves replacing your current mortgage with a new one. The difference, however, is you’ll need to make a lump sum payment in order to get approved for better loan terms.
- No-closing-cost refinance: If you want to refinance your home but are strapped for cash, a no-closing-cost refinance can help you avoid shelling out money for closing costs. However, this option may not be cheaper in the long run, as you may be stuck with higher interest rates and monthly payments.
- Reverse mortgage: If you’ve built up a lot of equity in your home (at least 50%), a reverse mortgage may be a good option for you. With a reverse mortgage, you can borrow against your home’s equity, but instead of you paying the lender, the lender would pay you.
- Debt consolidation refinance: If you own a home and have large amounts of debt, it may be worth considering a debt consolidation refinance. This is similar to a cash-out refinance, as you’ll take out more than what you currently owe on your mortgage and use that difference to pay off your debts.
Most car owners who choose to refinance their loans want to lower their monthly payments. If a borrower is in danger of defaulting on their debt, a restructured auto loan agreement can be helpful for getting their finances back on track.
However, banks usually have specific eligibility requirements for refinancing, including age-of-car restrictions, mile caps and outstanding balance limits.
If you're in financial distress and in need of a loan restructuring, it's best to reach out to your loan servicer and explain your personal financial situation.
Small business loans
Refinancing business debt is a common way for many small business owners to improve their bottom line.
Government-backed Small Business Administration (SBA) 504 loans, which are for purchasing real estate and equipment, can also be used to refinance conventional real estate loans. Similar to a mortgage refinance, switching to a different business real estate loan can often yield a lower interest rate and monthly payment.
Business owners overwhelmed with debt also use debt consolidation loans to restructure their payment plans.
Frequently asked questions
When refinancing a loan, your credit score can temporarily drop for a couple of reasons.
Lenders will typically require that you submit to a hard credit pull, which can cause your credit score to drop by a few points, though this will only stay on your credit report for up to two years.
Second of all, when you refinance a loan, you’re taking on new debt and have not yet proven that you’ll be able to repay it all, which may also impact your credit.
If market conditions have introduced lower rates, or your credit score has improved since you took out a loan, it may be a good idea to consider refinancing. You could secure lower interest rates, lower monthly payments or repayment terms that better fit your current financial position.
In some cases, you may save money by refinancing a loan. You can do this by finding a lower interest rate or a shorter repayment term.
However, it’s never a guarantee that you’ll save money by refinancing a loan. In some cases, the fees you may have to pay — such as closing costs and/or prepayment penalties — could negate any savings you may have otherwise earned.