Is Refinancing Your House or Car Always a Good Idea?
Point of Interest
Refinancing a home or car can help you lower monthly payments, reduce your overall costs and access equity — but you’ll need to tap into it at a favorable interest rate to make it work.
This may be a great time to refinance your home or car thanks to falling interest rates. After all, a lower interest rate means you’ll owe less money over the course of your mortgage or car loan … right? Well, it depends. There’s more to refinancing than paying less interest. While getting a better interest rate can decrease the amount you owe in the long term, it can also increase your monthly payments and other associated costs. Before you sign on the dotted line, consider your options and calculate precisely what a refinanced mortgage or car loan will mean for your finances. Let’s dive into some of the most common questions around refinancing, including: “Is refinancing a good idea in the middle of a loan?” and “How does refinancing work if you want to switch lenders?”
What is refinancing?
Refinancing a loan means you’re replacing your original loan with a new one that has different, and hopefully more favorable, terms. One of the most common reasons that people refinance is to lock in a better interest rate. This can happen because interest rates fall, your credit score improves or you discover a new type of loan with more appealing terms. Refinancing a home typically requires a lengthy application process, including an income assessment, credit check and review of your past payments. Refinancing a car also requires an evaluation of your finances and ability to repay. You’re in the best position to refinance your mortgage or refinance your car loan if you’ve been paying on time.
Common refinancing options
- Shorter term, higher monthly payments
- Longer term, lower monthly payments
- Lower interest rate
- Switch from adjustable to fixed interest rate
- Cash-out refinance
- Combine HELOC & mortgage
Shorter term, higher monthly payments
This kind of refinance will get out of debt more quickly, assuming you can afford to pay more every month. In some cases, you might not need to refinance your loan to increase your monthly payment (thereby decreasing the length of your term), but your original lender might charge a fee for doing so, which could make refinancing the most affordable option.
Longer term, lower monthly payments
If you can no longer afford your current monthly payments, you might be able to decrease them by extending the life of your loan. It will make your monthly budget more flexible, but remember, you’ll pay more interest over the life of the loan (and it’ll take you longer to pay it all back).
Lower interest rate
Refinancing at a lower interest rate generally means you’ll pay less overall and your monthly payments will decrease. However, it’s possible your monthly payments could stay the same, while the term gets shorter. Make sure to ask your refinance lender about your options if a lower interest rate is possible.
Switch from adjustable to fixed interest rate
If your loan rate is currently adjustable, the amount of interest you pay can change from month to month. A fixed rate can give you certainty, but it doesn’t guarantee you’ll always pay less than with an adjustable-rate mortgage (ARM).
In this scenario, you borrow more than what’s left on your current mortgage, and you receive the difference as a cash payment. Typically, you must have significant equity in your home to choose this option — usually at least 20%. If you’re interested, learn more about cash-out refinance rates.
Combine HELOC & mortgage
Instead of making separate HELOC and mortgage payments, you can refinance them into a single monthly payment.
Most of the options above can apply to car loans and mortgages, but one thing to remember is that unlike a home, a car usually starts to depreciate in value very quickly. So in some cases, your lender may actually insist you pay the difference between your car’s current value and what’s left on your loan before you refinance.
Why should you refinance?
- Pay less overall
- Reduce the length of your loan
- Lower your monthly payment
- Get cash out of your home equity
Pay less overall
When interest rates fall, refinancing usually means you can save you money in the long run, especially if you don’t extend your loan to a longer term. Take, for instance, a 30-year mortgage. If you refinance after 5 years but keep the same mortgage termination date, you’ll still have 25 years left on the loan — this time paying less interest along the way.
Reduce the length of your loan
Are you 10 years into your mortgage and ready to accelerate the pay-off? It’s understandable, but you’ll need to get out of your 30-year commitment. This is where refinancing enters the picture. You may be able to get a new mortgage with a shorter term and a new interest rate. Even if you incur prepayment penalties for the old loan, you can still pocket savings over the lifetime of the loan. Just know that it’ll probably mean your monthly payments go up.
Lower your monthly payment
Refinancing can also lower monthly payments. This happens a couple of different ways: You can extend the term of the loan or keep the term the same but take advantage of a lower interest rate. If you choose to extend the loan, be aware that even at a lower interest rate, you will probably pay more in the end. Still, if refinancing makes your monthly payment more manageable and keeps your mortgage current, it could be a responsible option. Use a refinancing calculator to work out various scenarios and decide which one is best for you.
Get cash out of your home equity
For some people, the motivator is cash. During the refinance process, you borrow more than the outstanding amount of your mortgage. The additional money might fund home renovations, large purchases, or allow you to pay off high-interest credit cards.
Risks of refinancing
- Falling into more debt
- Paying more over a long term
- Staying in debt longer
- Unsecured debt to secured debt
- Losing a favorable interest rate
- Incurring debt for risky investments
Falling into more debt
Refinancing can help to reorganize the entirety of your finances. That’s true especially since homes and vehicles are typically an individual’s largest assets. But it’s important to take care with how you leverage those assets. Some people refinance and then don’t follow through with an overall financial plan to stay out of debt.
“Financial experts recommend looking at refinancing as one aspect of an overall plan to get or keep your personal balance sheet in the black”
There’s the risk with refinancing that you free up additional cash, improve your credit rating, or otherwise give yourself additional breathing room. That’s great — but the second step is using that breathing room in a way that makes sense for your overall financial health. Financial experts recommend looking at refinancing as one aspect of an overall plan to get or keep your personal balance sheet in the black.
Paying more over a longer term
If you’re struggling to make your monthly payments, it can make sense to extend the life of your loan in return for cheaper payments. You may be less likely to default, which protects your credit rating and your asset, whether it’s a home or car. But the longer the term of the debt, the more you’ll pay in interest. Sometimes you can lock in a refinancing rate that’s so favorable, you can extend the term and still save — but make sure you do the math first.
Staying in debt longer
Longer loan terms mean you’re in debt for a longer period of time. Even if you’re smart with your money, you may face a crisis that means you can’t make payments, which could lead to the loss of the asset at a time when you’re already under a great deal of stress. The sooner you pay off your loan, the sooner the asset belongs to you.
Unsecured debt to secured debt
With any debt, you run the risk of defaulting on your payments. But if you refinance, you might be taking unsecured debt and turning it into secured debt, thereby risking losing an asset if you default. For instance, you might pay off credit cards by getting a cash-out refinance on your mortgage, but that debt is now secured against your house. If you can’t pay, you could face foreclosure. By contrast, defaulting on a credit card has other consequences, but it’s usually not as serious as losing your home.
Losing a favorable interest rate
Once you refinance, you lose the benefits of the previous loan. If you switch from an adjustable-rate mortgage to a fixed-rate mortgage, you have the certainty of a predictable cost, but sometimes an adjustable rate can decrease, saving you money. Before opting for a fixed rate, learn as much as you can about the adjustable rate you’re leaving behind. Know what index it’s tied to, and whether it may save you more money overall.
Incurring debt for risky investments
If you pay 5% on a refinanced loan to make 2.5% on a guaranteed investment or CD, you’re losing out over the long term.
Getting cash out of your home equity could provide a great opportunity, as long as you don’t use that opportunity to increase your exposure to risk. It may feel good to start an investment portfolio or contribute more to a money market account. On paper, you have more financial products than if you had stayed with your previous loan. But if you pay 5% on a refinanced loan to make 2.5% on a guaranteed investment or CD, you’re losing out over the long term. Investments that promise higher returns come with a higher risk profile. That means you could win big, or lose spectacularly.
Do you qualify for refinancing?
Getting approved for refinancing involves many of the factors you might expect, like a good credit score and a good payment history on your existing loan. Your new lender will ask for the same details you provided when you applied for the original loan: proof of income, assets, other debts, and any other information they feel is necessary before green-lighting a new arrangement. What is refinancing like for people who have less-than-perfect credit? You may still qualify, but you’re not likely to get the most appealing interest rates. It can often be smarter to build your credit before applying to refinance.
What’s the refinancing process like?
If you decide that refinancing is right for you, you’ll begin by applying for the loan. You don’t have to go to your current lender to refinance, but if you’ve established a positive history with your lender, they may be more likely to approve the application. That being said, don’t be afraid to shop around for the best rates and terms or plug the numbers into a refinancing calculator and figure out different scenarios. Alternative lenders can also give you a quote on a new mortgage or auto loan.
Once you have a lender and are happy with the interest rate, make sure you can afford fees. For a home mortgage, this includes the loan origination fee, appraisal fees, application fee, and other closing costs. From there, your lender will walk you through the paperwork and let you know when your refinanced loan funds. This pays off your previous loan. If you are switching lenders, your relationship with the first lender ends as soon as your original loan is paid off.
Make the decision that’s right for you
With interest rates favorable to borrowers, you may have more options today than you did a few years ago. Refinancing your home or auto loan can make good financial sense, but take into account the potential drawbacks and establish a plan before meeting with potential lenders.