When you take out a loan, you must make the required payments according to the loan agreement. But what happens if you can’t afford the payments or interest rates drop? Can you refinance a loan and take advantage of the better terms?
The good news is yes, most people can refinance their loan, whether it’s a personal loan, auto loan, or mortgage. The requirements may differ, but the process is the same. Understanding how to refinance your loan, decide when it is (and isn't) a good idea, and understanding the pros and cons will help you decide if it’s right for your situation.
The Step-by-Step Process
Remember when you applied for your loan? You completed a loan application and went through the underwriting process, right? Refinancing has the same process, but with a few more decisions.
Check Your Credit
You don’t need perfect credit to refinance, but decent credit helps you get the best terms. Before you apply or get pre-qualified, check your credit and see if any changes are necessary. Are you late on your bills? Did you overextend your credit cards? Take care of any ‘bad’ credit before applying. It's also a great time to do whatever you can to boost your credit score, as it will play a key role in determining your new rate. You'll also want to lift any credit freezes in advance.
Apply For The New Loan
We recommend shopping around and/or applying at several banks/financial institutions. See what each lender offers, as they’ll have different requirements and terms.
Get A Payoff From Your Current Lender
When you refinance a loan, you pay off your existing loan and replace it with a new one. You’ll need an exact payoff amount according to the payoff date, so it includes the accumulated interest. This is information you can get by calling your current lender.
Compare The New Loan To Your Existing Loan
Compare the interest rates and loan terms – are you getting a lower interest rate? Will the monthly payment decrease? How much are the closing costs? Determine if you’ll save money monthly and over the life of the loan after you consider the closing costs. If the closing costs are high, you may not save as much money as you think.
Process The Loan
Once you choose a loan, you’ll go through the underwriting process like before. The lender needs your financial documents (pay stubs, W-2s, tax returns, and bank statements). You’ll also provide your employment information so the lender can verify it, ensuring you can afford the new loan.
Close On Your New Loan
Once you sign the paperwork for the new loan, the lender will pay off your old loan with the proceeds of the new. From that point, you’ll make payments to your new lender on your new due date.
Make Sure Your Old Loan Was Paid In Full
Call your old lender or check your account online to make sure the old loan was paid in full – otherwise interest will keep accumulating, which you are responsible for.
When is Refinancing a Good Idea?
Even though refinancing costs money, it makes sense in certain situations:
Interest Rates Dropped
If rates dropped enough to cover the up-front costs associated with a refinance, not only will your monthly payment go down, making it easier to afford your payments and/or it will cost you less over the life of the loan, but your total costs over the life of the loan will be lower as well.
Your Credit Score Increased
If you took out the loan when you had poor credit or a not-so-good financial situation and have since improved, you may get better loan terms including a lower interest rate now. This may save you money monthly and over the loan’s term.
You Want To Pay The Loan More Quickly
If your financial situation has improved since you took out the loan, you may want a shorter term to pay the loan off faster. If interest rates fell and you can afford the higher payment of a shorter term (you pay more principal) it may make sense to refinance.
You Want Better Terms
Did you take an adjustable interest rate loan and now want a fixed rate? ARM or variable rate loans are unpredictable. Interest rates may change monthly or annually. Taking advantage of low fixed interest rates makes budgeting easier and takes the anxiety out of making your payments.
You Have A Balloon Payment
A balloon payment requires a lump sum payment at the end of its short term. If you don’t have the funds to pay the debt off, you can refinance into a longer-term loan to avoid it.
What Loans Can you Refinance?
You may refinance just about any loan, even credit card debt as you can consolidate them with a personal loan or home equity loan. Besides credit card debt, the most common loans to refinance are:
- Mortgage (1st or 2nd)
- Personal loan
- Auto loan
- Student loans
Pros of Refinancing a Loan
- You may save money – If you can get a lower interest rate or better term, you may save money monthly or over the life of the loan. For example, if you can afford a shorter term, your monthly payment may increase, but you’ll pay less over the life of the loan because you’ll pay interest for a shorter time.
- You can change the loan’s terms – You can extend or reduce your loan’s term based on your needs. If you need lower payments, you can take a longer term; just pay attention to the higher interest you’ll pay over the loan’s term. If you reduce the term, you save money.
Cons of Refinance a Loan
- It costs money – Most loans have closing costs. Calculate your savings over the loan’s term including the closing costs to determine if refinancing makes sense. If closing costs are too high, refinancing may not make sense.
- You may have a prepayment penalty – Check your current loan. If it has a prepayment penalty, you’ll pay about 2% - 3% of the loan’s balance to pay it off early.
- Your interest payments may increase – If you extend your term, you’ll pay more interest over the life of the loan. Your interest rate may even increase. If you can’t afford your payments, you may not have a choice, but know the full cost of the loan.
Knowing how to refinance and determining if it makes sense is important before jumping in because you hear interest rates dropped. Lenders offer great rates today, just make sure it makes sense for your financial situation first.