Refinancing is the process of revising and replacing the terms of an existing credit agreement, usually in the form of a loan or mortgage. When someone refinances, they’re replacing an existing loan with a new loan that pays off the debt of the first one. People refinance loans for a variety of reasons. Most do so in order to obtain more favorable borrowing terms like a lower interest rate, lower monthly payments, or shorter repayment periods. But while there are many advantages to refinancing loans, in certain scenarios doing so could put someone at a disadvantage. Whatever the case may be, people should take the time to make sure refinancing will work in their favor. If it will, it can lead to a lot of savings!
Paying less interest
If someone had poor or no credit when they first took out a loan, it’s likely they were given a higher interest rate. If their credit has improved since that time, they may qualify for a lower interest rate when refinancing. An interest rate is the amount a lender charges for the use of funds. The charge is expressed as a percentage of the original loan. The lower the interest rate, the less interest someone will pay over the life of a loan. For example, let’s say someone takes out a $20,000 auto loan at 10% – with a repayment period of five years. After paying $424.94 every month for a year, they decide to refinance at a new rate for the
remaining four years. If they refinance the remaining $14,900.72 at 4%, their new payment will be $335.77 per month, for a monthly savings of $89.17. By the time they finish paying off the loan, they’ll have saved a total of $4,280.16 by refinancing.
Lowering monthly payment
A lower interest rate on a refinanced loan can lead to lower monthly payments. This could free up money to pay off other, higher-interest debt. Or someone could use the savings to build up an emergency fund, or save the money in a retirement account. For an even larger reduction in their monthly payment, people can extend the term of their loan when they refinance. They would then have lower monthly payments – but this might mean they’d be paying more in interest over the life of the loan.
Paying off the loan sooner
If someone has student loans, a car payment, or a mortgage, they can always pay extra on top of their current payments to pay a loan off sooner. This is known as “paying extra on principal.” Principal is the loan amount before any interest is added. If a person’s credit has improved, refinancing with favorable terms can help them streamline the process and maximize savings.
Potential for extra fees
Some lenders charge a prepayment penalty for paying loans off early. This is to encourage borrowers to pay back their principal slowly over a longer term, allowing the lender to collect more in interest. This is more common with mortgages than other types of loans. By refinancing, the original lender may charge the penalty. Some refinancing lenders also have application fees and, although this is not common, if the lender does have fees, people should compare the total amount of fees with how much they’d save by refinancing. If the fees total more than the potential savings, refinancing would not make financial sense.
Potential of paying more interest
Stretching loan payments over a longer term to save money each month may mean paying more interest over the life of the loan – even if it’s at a lower interest rate. While a reduced rate will often result in lower overall costs, a few extra years of interest on payments can add up.
Potential to lose federal benefits
Refinancing federal student loans might not be the best idea – despite more favorable terms. Someone with federal student loans may be eligible for federal benefits. These benefits include forbearance or even student loan forgiveness. For example, since March
2020, federal student loan borrowers have been eligible for forbearance. This means no payments have been required and all the interest rates on student loans were automatically set to 0%. Further, most student loan forgiveness programs are only available to borrowers with federal loans, not private.Refinancing a federal student loan makes it a private loan.
Weigh the pros and cons
Weighing the pros and cons of refinancing before making any decisions is always a good idea. Under the right circumstances, refinancing can save people a lot of money. Anyone planning to refinance should know their goal – whether it be lowering the monthly payment or paying off the loan sooner. Next, use a refinancing calculator, such as the one at calculator.net, to compare the current loan with a refinancing offer to determine which is the most cost effective. Refinancing is not always the best choice, so people should take the time to consider whether or not refinancing will work in their favor.