The concept behind refinancing a loan is simple. Essentially, you’ll be paying off your old loan with new money and taking out a new loan to replace the old one. It may seem like a lateral financial move on the surface, but in the right circumstances, it can grant you a number of short-term and long-term financial benefits.
Refinancing is most commonly known as a technique used for home mortgages; you can replace your old home loan with a new one to save thousands of dollars over the lifespan of the home. However, you can also refinance other loans; for example, you can refinance your student loans to lower your monthly payments.
So how does refinancing work? And what are the main motivations to do it?
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Why People Refinance Loans
Most people who refinance are motivated by one or more of the following:
- A lower interest rate. One of the most common reasons people refinance is to secure a lower interest rate. For example, let’s say you took out a loan for $100,000 and you paid a 4 percent annual interest rate; this results in $4,000 of interest rate payments per year (assuming it’s accrued annually), or $333 per month. If you can get a refinanced loan for 2.5 percent, that would mean $2,500 of interest rate payments per year, or $208 per month. As long as you’re not losing anything else by taking on this new loan, this financial move is a no-brainer.
- A fixed interest rate. In some types of loans, consumers have the option of choosing a fixed interest rate or a variable interest rate. In a fixed rate loan, the interest rate is locked; it cannot change. In a variable rate loan, the interest rate will go up and down based on market conditions. In some cases, this can be favorable to the consumer, but in many cases, the consumer ends up paying a higher interest rate than they originally did. Refinancing could allow a consumer in this situation to revert to a more stable, fixed rate.
- Longer terms. Some people may refinance as a way to seek longer terms. For example, having a 15-year mortgage is an aggressive strategy that allows you to pay off your home faster, but in the meantime, you’ll have higher monthly payments. Refinancing could allow you to extend those terms to 30 years, increasing the lifespan of your loan but reducing your monthly payments.
- Shorter terms. The reverse is also possible. If you originally financed with 30-year terms but you’re interested in paying off your home faster (and/or getting a lower interest rate), you may want to refinance for 15-year terms. This can be advantageous for several reasons.
- Lower monthly payments. There are several factors that, working together, can ultimately help you pay less per month when refinancing. Depending on your situation, you could find a lower interest rate, longer terms, and/or a better lender with lower overall fees. Working together, these items could easily save you hundreds, or even thousands of dollars per month (depending on the amount of your loan).
- Overall loan restructuring. Sometimes, people refinance because they carry many different types of debt and they’re interested in restructuring these items. For example, let’s say you have a mortgage with a 4 percent interest rate and credit card debt with a 20 percent interest rate. With refinancing, you may be able to pay off your old home loan and take out a new one – one that immediately gives you extra capital, which you can use to pay off part of your credit card debt. In effect, this debt is “transferred” to your home loan, which has a much lower annual interest rate.
- Access to additional capital. Of course, you may also choose to refinance if you’re in need of some additional capital. If you have significant equity in your current home, refinancing could allow you to free up that money and use it for something else. For example, you may have a child who’s about to enter college; the extra money could help them pay for tuition. You may also be interested in a significant home upgrade, like remodeling the kitchen or bathroom.
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Is Loan Refinancing Right for You?
There are many good reasons to refinance a loan, whether you want to take control over your student debt or just restructure your current monthly mortgage payments. However, loan refinancing isn’t the right financial move for everybody, or for all situations. Make sure you review your options carefully, studying different loans that are currently available and understanding how your short-term and long-term payments will change under each new model. Don’t make a move until you’re certain it’s going to work out in your favor.