Thanks to low interest rates, the U.S. is in the middle of a refinancing boom. It’s easy to understand why — who wouldn’t want to decrease the interest rate on their home or car? Logically, a lower interest rate means you’ll owe less money over the course of paying off your mortgage or car loan. However, 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.
What is refinancing?
Refinancing a loan is essentially replacing your original loan with a new one. You can either keep the loan with the original lending institution and refinance it with better terms, or transfer it to a new lender. Once you refinance, the terms of the old loan no longer exist — you’re entirely under the rules of the new agreement.
What are common refinancing options?
You can refinance a loan in several ways, but the best choice for you depends on your reasons for refinancing. While many people want to owe less over the long term, that’s not the case for everyone — you might want to use a refinancing strategy to achieve something else.
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).
Cash-out refinance: 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%.
Combine HELOC and 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
One of the most common reasons to refinance is because it may be cheaper. Refinancing with a lower interest rate usually means you pay less over the life of the debt — assuming you stick to the same term. If you have a five-year term on a car loan, but refinance at a lower interest rate after the first year for the remaining four years, it should cost you less than if you had stayed with the original contract.
Reduce the length of your loan
Perhaps you don’t want to have a mortgage a few decades from now. That’s understandable, but it means getting out of that 30-year commitment. Refinancing can help with this. You may be able to get a new mortgage with a shorter term that costs you less in interest. You may incur prepayment penalties for the old loan, but 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 help you pay less every month by extending the term of the loan, or by keeping it the same but taking advantage of a lower interest rate. But even at a lower interest rate, you will probably pay more overall than with a shorter term.
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
There are plenty of reasons why you might want to refinance, but there are also a few potential drawbacks.
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.
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
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’s the refinancing process like?
If you decide that refinancing is right for you, starting the application process is the next stage. 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. However, there’s nothing stopping you from going to an alternative lender who may offer a better rate or better terms.
Since refinancing is a big step, it’s a good idea to shop around. Alternative lenders may give you a quote on a new mortgage or auto loan. You can look into current mortgage rates to see if refinancing makes sense to begin with. If the deals are particularly good, you may want to develop a strategy that uses refinancing to improve your overall financial situation. After all, the best savings accounts, personal loans, and mortgages are those that are right for you, given your individual circumstances.
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.