Since the COVID-19 pandemic, you may have heard a constant buzz about people refinancing everything from their mortgages to personal auto loans. Interest rates have fluctuated drastically in the past few years, and what was once realistic for people to pay month to month may no longer be possible.
If you’re looking for a way to adjust your monthly payments or obtain a better interest rate on a loan, refinancing is the way to do so. However, it all has to do with when you refinance, so here’s everything you need to know about what refinancing is and when you should go through the process.
What is Loan Refinancing?
Refinancing is when a borrower revises and replaces the conditions of an existing credit agreement or loan to improve the interest rate, payment schedule, or other terms outlined in their original agreement. You can refinance loans like mortgages, auto loans, credit card balances, and student loans.
Borrowers may choose to refinance a loan for several reasons, including:
Extending the repayment term
Borrowers may be struggling to meet their current monthly payments. An easy solution for this is refinancing the loan. When you extend the loan term, you pay less monthly. However, be mindful of the fact that this will likely mean you’ll pay more toward the loan overall.
Improving their credit score
Borrowers who obtained a loan when their credit score was lower may not have been able to negotiate competitive loan terms. For example, there may have been a higher interest rate associated with the loan term due to the perceived risk to the lender. If they refinance when their credit score improves, then this can help them pay less in interest throughout the loan.
Obtaining a more competitive interest rate
Attaining a more competitive interest rate is often what drives refinancing. When you have a lower interest rate on your loan, you’ll pay less in total. You essentially earn yourself a big discount by making this change!
How Does Refinancing Work?
If you’re ready to reap the benefits named above, then refinancing could be for you. To refinance, you’ll apply for an entirely new loan to pay off your original loan. You can do this through either your existing lender or a new one.
Remember, in an ideal world, you’ll obtain better terms in this new loan agreement than in your old one. However, sometimes borrowers refinance to accommodate a new expense or financial need.
When Is the Best Time to Refinance?
The best time to refinance a loan is when you’ll save money by doing so. Here are the top scenarios in which you should consider this option:
You’ve seen interest rates drop
During the first few months of the pandemic, the Federal Reserve Board (“the Fed”) lowered interest rates to stimulate economic growth. During this time, many borrowers decided to refinance loans like mortgages, knowing it would ease their monthly payments or allow them to pay off their homes faster.
Since then, interest rates have crept back up. That said, if they were to drop, borrowers who have taken out loans since would benefit from refinancing.
You’ve improved your credit score since applying for the loan
Now, keep in mind that refinancing a loan can also impact your credit score. You can see your score dip initially in the months following this event. However, it can improve it long-term, as you’ll lower your debt and monthly payment. If you’re able to absorb the short-term impact on your credit score, this can be a smart move.
You want to switch your rate type
Some loans have a variable APR, which means your rate can go up and down with the index interest rate. When this is the case, many people find it difficult to make their monthly payments on a fixed income. They never know what their payment is going to be. Additionally, if interest rates are increasing, you’ll continue to pay more and more, which is often unsustainable. Refinancing from a variable to a fixed rate can help remedy this issue.
You don’t want a balloon payment
Balloon payments are larger payments associated with some personal loans. These large payments are often at the end of a loan term, and not everyone wants to be responsible for paying such a large chunk. To avoid it, they’ll refinance the loan to get on a different payment schedule.
You require lower monthly payments
Some borrowers opt to refinance to meet their monthly payments. If you’ve had a change in your financial circumstances — i.e., you’ve lost your job or reduced your income — lowering your monthly loan payment can allow you to make ends meet.
Although reducing your monthly payments will extend the loan term and cause you to pay more interest, it can help keep you afloat for the time being. Lenders are often very willing to help borrowers who call them and let them know they are struggling to meet payments. Refinancing is one of the options that they will offer to help you meet your monthly payments.
You want to pay off your loan faster
One motivation that borrowers have for refinancing is to pay off their loans faster. If you’re financially able, refinancing to a shorter loan term will help you save money on interest.
You understand the fees associated with the process
One of the drawbacks of undergoing the refinancing process is that there are fees associated with it. Some lenders charge application fees, while others charge fees for paying off loans before the repayment period ends. If you’re considering refinancing a loan, ensure you do the math on how much fees will cost you. In some cases, it may not make financial sense after you’ve factored in these additional costs.
When the time is right, refinancing a loan is a stellar option for everyone. Whether you’re financially stable or falling on hard times, refinancing allows you to reorganize the way you’re handling your debt. Just be sure to refinance strategically — when interest rates drop, you boost your credit score, or you have another calculated purpose for doing so.