When Refinancing Makes Sense
Last Updated: April 17, 2020
One good thing about having expensive debt is the possibility of converting your current loans to a better one. While refinancing may potentially save you money, it can backfire if done incorrectly. Knowing how, and when, to refinance is just as important as refinancing itself.
How Refinancing Works
Refinancing is substituting an existing loan with a new one. The purpose of the new loan is to pay off the current debt. The terms of the refinanced loan depend on the agreement between you and your lender.
Refinancing follows the same basic process:
- The borrower thinks the loan is too expensive to continue as-is.
- A lender with better terms is identified and the borrower applies for a new loan with them.
- The new loan completely eliminates the old debt.
- The borrower makes monthly payments as agreed until the loan is paid off or refinanced.
Reasons to Refinance
There are several good reasons to refinance a loan.
- Lower interest costs. Refinancing makes sense if the new loan’s interest rate is lower than the existing interest rate. Lower interest rates applied to long-term or high-value loans can result in significant savings.
- Lower monthly payments. Refinancing restarts the clock on the loan’s life. Your loan’s balance is usually smaller during a refinance, and you may pay less interest over the loan’s duration. Now, you’ll have a lower balance and less expensive interest costs spread over the same period of time. Your monthly payments should decrease.
- Shorten the loan term. You may choose to refinance your loan for a shorter term, opening up access to a lower interest rate.
- Consolidating debts. It may be best to compile multiple loans (with different interest rates) into a single loan with a lower rate.
- Changing the type of loan. Depending on the situation, it may be beneficial to switch loan types. (For example, converting your variable-interest loan to a fixed one.)
- Fully paying off a loan come due. Some loans (for example, for a business) may need to be paid as a lump sum. Refinancing may allow you to pay off the debt as agreed while converting it into long-term debt with more manageable payments. For this to happen, the borrower would have had to establish themselves with a solid history of on-time payments.
Disadvantages of Refinancing
Despite all the advantages, refinancing may not always be the best decision. The initialization costs may be too expensive, or the current loan’s terms may be better than the refinancing offer. (For example, the interest rates may be higher today than for the existing loan’s terms.)
Before refinancing, you must understand all the new loan’s costs. Do not focus on the low monthly payment only.
- Transaction costs. These may be expensive; make sure that the benefits are worth the cost before taking on the new loan.
- Some loans issue penalties for paying off the loan early.
- Higher overall interest costs. Restarting the loan adds more to the lifetime cost of the debt, even though the monthly interest cost is lower. It’s best to run the numbers through a calculator before you refinance.
- Lost benefits. You’re replacing one loan with a different loan. Any favorable features of the old loan may be lost upon converting to the new one.
Refinancing makes sense if it will save you money. Rerun the calculations as often as you need to so that you’re confident in your decision. You’ll want to make sure that refinancing is the best thing to do for your debt situation.