When you take out a loan, you agree to pay back money borrowed over a certain period of time and at a set interest rate. Sometimes, loan terms are favorable (low rate, short repayment period). In some cases, you wind up paying way more than it’s worth. That’s where refinancing comes in.
With refinancing, you can take advantage of new and better loan terms. You pay less per month and may save on interest. But refinancing isn’t always a good idea.
Here’s what you need to know:
What is Refinancing?
When you refinance a loan, you replace an existing loan with a new one. The new loan pays off the old loan, but it offers better terms and features. Usually, this means that you pay a lower monthly payment and pay less interest overall.
When most people talk about refinancing, they refer to mortgages. But you can refinance any kind of loan:
- Auto loans
- Personal loans
- Student loans
People refinance loans for a number of reasons:
- Lower their interest rates
- Lower their monthly payments
- Switch from one type of loan to another (e.g. adjustable-rate mortgage to a fixed-rate mortgage)
- To pay off the loan faster (you can refinance with a shorter loan term)
- To get access to cash
Refinancing may make sense if:
You have a better credit score, which means you’ll get a better rate.You will come out ahead financially (you’ll save money because of lower rates and lower monthly payments).
Let’s say that you took out a 30-year mortgage in 2006. At the time, interest rates were 6%-7%. Today, refinance rates are a lot lower – 3% to 4%. Refinancing could shave 2% off your interest rate and potentially save you hundreds of dollars a month.
If you’re thinking about refinancing, a refinance calculator can help you figure out whether it makes financial sense for you.
How Does Refinancing Work?
The process of refinancing a loan is really no different from taking out any other type of loan. You’ll need to have good credit and you’ll need to go through the usual approval process.
The process may involve:
- Choosing a loan program. If you’re refinancing a mortgage, you may be able to choose between adjustable-rate and fixed-rate loans. Your lender will explain your loan program options.
- Submitting documents. You’ll need documents proving your identity and income. Tax documents, credit verification, and other documentation may be required by your lender.
- Fees and other costs. Mortgage refinancing is usually riddled with fees (deposits, closing costs, etc.). Refinancing an auto loan may not be as expensive (title change may be the only big fee).
It can take anywhere between 60 and 90 days to refinance a loan, from application through approval.
When is Refinancing a Bad Idea?
Refinancing isn’t always a smart financial move. Here are some bad reasons to refinance:
- You want to consolidate debt.
- You want to take cash out of your home to invest it.
- You want to lower your payments by stretching out your loan over a longer-term. You’ll only pay more in interest over the loan term.
- Your credit score dropped since you took out the original loan.
If you’re thinking about refinancing a loan, weigh your options carefully and make sure that the terms are more favorable than your current loan terms.