What is Loan Refinancing?
Loan refinancing involves taking out a new loan, usually with more favorable terms, in order to pay off an old one. Terms and conditions of refinancing vary widely depending on the lender and economic climate. Refinancing is most commonly associated with home mortgages, car loans, and student loans. In the case that old loans are tied to collateral (assets that guarantee loans, like a house), they are transferred to the new loan.
If the replacement of debt occurs under extreme financial distress to prevent default, it is called debt restructuring instead. Restructuring is a process to reduce and renegotiate delinquent debts to restore liquidity.
Top Reasons to Refinance
- Save Money (Lower Interest Rate): If a borrower negotiated a loan during a period of high interest rates, and rates have since decreased, it may be possible to refinance to a new loan with a lower rate. It is also possible to refinance when a borrower's credit score improves significantly, qualifying them for better terms.
- Need Cash (Cash-Out Refinance): The balance of a loan decreases during the payback process. When enough equity has accumulated, the borrower may cash out by refinancing the loan (mostly home mortgages) to a higher balance. The difference goes to the borrower in cash. However, unless accompanied by a lower interest rate, cash-out refinancing can be expensive.
- Lower Payment Amount: Borrowers struggling to meet the minimum monthly payments can refinance to a new loan with a longer term, which lowers the required monthly payment. However, this will increase the total lifetime interest paid.
- Shorten the Loan: Borrowers can potentially pay off their existing loans faster by refinancing to shorter loan terms. One of the most common examples is refinancing a 30-year mortgage to a 15-year mortgage, which typically comes with a lower interest rate but a higher monthly payment.
- Consolidate Debt: Managing one loan with a single payment date instead of multiple loans is much simpler. This can be achieved by refinancing multiple high-interest loans (like credit cards) into a single loan with a lower blended interest rate.
- Switch Rate Types: It is possible to use loan refinances to switch from an Adjustable-Rate Mortgage (ARM) to a Fixed-Rate Mortgage in order to lock in low rates and protect against a rising rate environment.
Common Mortgage Refinance Costs
When refinancing mortgages, there are a number of standard fees that apply. You must factor these "closing costs" into your decision to ensure the long-term interest savings actually outweigh the upfront costs. Our calculator determines this exact "Break-Even Point" for you.
- Mortgage Application Fee: Lenders may charge a flat fee or percentage of the loan amount to process applications, approved or not.
- Home Appraisal: Lenders usually require an appraisal of the house value to evaluate whether borrowers have enough equity for a successful application. This typically costs a few hundred dollars.
- Loan Origination Fee or Mortgage Points: Normally 0-2% of the loan amount, used as compensation for putting loans in place. Buying "points" lowers your interest rate by paying more cash upfront.
- Title Search & Insurance: Paid to a title company to research court records and property databases to guarantee the title is free and clear of liens.
- Inspection & Survey Fees: Fees to evaluate the condition of the property (plumbing, roofing, pests) or to ensure proper boundary lines.
Refinancing Other Loan Types
Student Loans
In the U.S., refinancing federal student loans means they are no longer considered federal loans, but private loans. You will lose all federal benefits, such as Income-Driven Repayment (IDR) plans, deferment, forbearance, and potential Public Service Loan Forgiveness (PSLF). Refinancing is generally only recommended for private student loans, or for borrowers with high-interest federal PLUS loans who have high, stable incomes and excellent credit scores.
Car Loans
It is possible to refinance a car loan to increase the length of the loan, thus reducing the size of the monthly payments. However, beware of "upside-down" auto loans, which refer to loans where the amount owed is more than the book value of the vehicle. This often occurs when refinancing to a longer loan, since the value of the car depreciates rapidly. Additionally, check your current contract for prepayment penalties before refinancing.