What Does It Mean to Refinance a Loan?

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 to 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.

Loan Refinancing Explained

Refinancing a loan allows a borrower to replace 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 old loan are replaced by the updated agreement. This enables borrowers to redo their loan to get a lower monthly payment, different term length or a more convenient payment structure. Most consumer lenders who 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. For example, a homeowner with good credit who took out a 30 year mortgage in 2006 would likely be paying an interest rate between 6% and 7%. Today, the most qualified borrowers can receive interest rates lower than 4%. Accordingly, that homeowner could shave more than 2% off of their interest rate by refinancing their loan, saving them hundreds of dollars a month.

30 Year Mortgage Before RefinancingAfter Refinancing
Interest Rate6.75%4.00%
Monthly Payment$1,946$1,432
Savings$514

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.

Student Loans

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 payment.

Credit Cards

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.

Mortgages

The two main reasons that homeowners refinance their mortgages are to lower their monthly payment or to shorten their term length from a 30 year mortgage to a 15 year mortgage. For example, homeowners who financed their home purchase with an FHA mortgage—a government-backed product that allows for a low down payment—are required to pay more mortgage insurance than homeowners with conventional mortgages, which only require insurance until 20% equity is reached. An FHA borrower who's hit the 20% mark could refinance into a conventional mortgage to stop paying mortgage insurance.

Similarly, many borrowers switch into a 15 year mortgage to pay down their mortgage quicker. If the cash is available to make a bigger payment each month, a shorter term can save a lot of money on interest rates; they're lower for 15 year loans, and interest won't be accruing for so long.

For all 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 dollars might not be worth the time and money that goes into getting a new loan.

Auto Loans

Most car owners choose to refinance their loan 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 communicate to them 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 SBA 504 loans, which are for purchasing real estate and equipment, can also be used to refinance conventional real estate loans. Similar to mortgage refinances, switching into 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 plan.

How to Refinance a Loan

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. 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. After finding the value of your current loan, you can comparison shop between a few lenders to find the terms that best fit your financial goals.

Whether you're looking to change term lengths or lower your interest rate, a variety of loan options are available on the markets today. With new online lenders looking to compete with traditional banks, there are services and packages tailored towards all financial goals. For the most qualified borrowers, this competition can help cut the costs of a loan by hundreds or thousands.

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