How refinancing works: advantages and disadvantages of new loans


If you have a loan that is too expensive or too risky to live with, you can often refinance into better credit. Things may have changed since you borrowed money, and there may be several ways to improve the terms of your loan. Whether you have a home loan, car loan or other debt, refinancing allows you to move your debt to a better place.

What is refinancing?

What is refinancing?

Refinancing is the process of replacing an existing loan with a new loan.

The new loan pays off current debt so that the debt is not eliminated when you refinance. However, a new loan should have better conditions or opportunities that improve your finances. The details depend on the type of loan and your lender, but the process usually looks like this:

  1. You have an existing loan that you would like to improve in some way.
  2. You find a lender with better loan terms and you apply for a new loan.
  3. The new loan fully repays the existing debt.
  4. You pay the new loan until you have paid or refinanced.

Why people and businesses refinance?

Why people and businesses refinance?

Refinancing is time-consuming, expensive, and new credit may lack the attractive features offered by existing credit. Then why go through the process? There are several potential benefits to refinancing.

Save money: A common reason for refinancing is to save money from interest expense. To do this, you usually need to refinance into a loan at an interest rate lower than your existing interest rate.

Especially with long-term loans and large dollar amounts, lowering the interest rate can lead to significant life savings.

Lower Payments: Refinancing can lead to lower monthly payments required. The result is easier cash flow management and more money available in the budget for other monthly expenses.

When you refinance, you often restart the clock and extend the amount of time you will take credit for. Since your balance is likely to be less than your original credit balance and you have more time to repay, the new monthly payment should be reduced.

A lower interest rate (with all other things remaining the same) can also lead to a lower monthly payment. However, simply extending the loan term can actually mean that you will pay more for the loan in the long run. To see how interest rates and your credit term affect your monthly cash flow, see how to calculate your loan payments.

Shorten the Credit Term: Instead of extending the repayment, you can also refinance into a short-term loan. For example, you may have a 30-year home loan, and that loan may be refinanced into a 15-year home loan. This move may make sense if you want to make bigger payments to get rid of debt quickly. Of course, you can also pay for free without refinancing. Making bigger payouts without refinancing will help you avoid paying the closing costs and keep some flexibility (you can pay more than the minimum, but you don’t have to if something comes up).

Debt Consolidation: If you have multiple loans, it might make sense to consolidate those loans into one single loan – especially if you can get a lower interest rate.

It will be easier to keep track of payments and loans, but consolidation can cause problems (see below).

Change your loan type: Even if you do not reduce your interest rate or your monthly payment, it may make sense to refinance for other reasons. For example, if you have a variable rate loan, you might want to switch to a fixed rate loan. A fixed interest rate could offer hedging if rates are currently low, but it is expected to increase.

Pay off debt due: Some loans, especially balloon loans, have to be repaid on a specific date. But you may not have the resources at your disposal for a large lump sum payment. In those cases, it might make sense to refinance the loan – using a new balloon financing loan – and take more time to repay the debt.

For example, some business loans are due after only a few years, but they can be refinanced into long-term debt once the business is established and has shown a history of payments on time.

Disadvantages of refinancing a loan

Disadvantages of refinancing a loan

Refinancing is not always a wise move. Even if you provide a lower interest rate or a lower monthly payment, it can be a mistake to get rid of your existing loans. Evaluate the benefits and benefits carefully before moving forward.

Transaction Costs: Refinancing can be expensive. Especially with loans such as home loans, you pay closing costs that can add thousands of dollars. You want to make sure that you get more rest even before you pay those costs. Other types of loans, including loans from online lenders, may include processing and origination costs.

Higher Interest Costs: Refinancing can backfire. When you pay off over a longer period of time, you pay more interest on your debt. You may enjoy lower monthly payments, but this can be offset by higher living costs of borrowing. Run some numbers to see how much it really refinances for you. Accelerate loan amortization to see how your interest costs change with different loans.

Lost Benefits: Some loans have useful features that will be eliminated if you refinance. For example, student loans are more flexible than private student loans if you fall into difficult times. Plus, loans can be forgiven if your career involves public service. Also, keeping a fixed rate loan can be ideal if interest rates are accelerating – even though you are temporarily getting a lower rate with a variable rate loan.

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