Refinancing is a solution to expensive and risky existing debts. The borrower’s personal situation, as well as the market, may have changed significantly since they took out the original loan. There could be a wider range of options available today, offering improved loan terms. Whether the loan was taken out to cover a car purchase, home loan, or other debt, refinancing enables individuals to shift their debt to a better place.
Refinancing enables borrowers to secure a new loan, using the proceeds to pay off the old loan. The new loan should offer better features or terms to improve the borrower’s finances. Finer details depend on the lender and the loan terms, but the refinancing process generally consists of four key stages:
- Identifying improvements that could be made to an existing loan
- Finding a lender offering better loan terms and applying for the loan
- Using the proceeds from the new loan to pay off an existing loan in full
- Making repayments on the new loan until it is repaid or refinanced
The Advantages of Refinancing
Refinancing a loan can offer several key advantages. It enables borrowers to:
- Save Money: To reduce interest costs, borrowers need to refinance with a new loan that has a lower interest rate. With large or long-term loans, securing a lower rate of interest can result in significant savings.
- Shorten the Loan Term: Borrowers can refinance to shorter-term loans, for example transitioning from a 20-year home loan to a 10-year loan. Shorter loans often come with lower interest rates. In addition, since the loan is repaid over a shorter duration, this should further reduce interest payments. However, borrowers can always make extra repayments to an original loan without refinancing, and through doing so maintain flexibility while avoiding closing costs.
- Reduce Loan Payments: Refinancing can lead to lower monthly repayments. This can improve cash flow management, enabling borrowers to better budget for monthly expenses. When a borrower refinances, they effectively restart the clock. They can extend the amount of time over which they wish to repay the loan. Since the loan balance is to be smaller than the amount of the original loan, and the borrower typically has more time to repay, this should result in a decrease in monthly payments.
- Change Loan Terms: A variable-rate loan may have been the most attractive option when the original loan was taken out. Nevertheless, over time, things can change. Borrowers may wish to transition to a fixed-rate loan, offering them protection if interest rates are currently low, but predicted to rise.
- Debt Consolidation: Where a borrower has multiple loans, it may be prudent to consolidate them into a single debt, particularly if they can secure a lower interest rate. This could not only save them money, but make it easier to keep track of loan terms and payments.
- Repay a Loan That Is Due: Some loans, for example balloon loans, are repaid on a specific date. The borrower may have insufficient funds at that time to make a large loan repayment. In such cases, they may need to refinance, using a new loan to fund the loan repayment.
Disadvantages of Refinancing
Refinancing can be time consuming. It can also be expensive. Upfront costs, such as closing costs, may be high, and the benefits of the current loan may outweigh savings obtained through refinancing.
Refinancing can backfire where borrowers fail to achieve a lower interest rate. Where loan payments are stretched out across an extended period, borrowers may find themselves paying more interest. Though they may enjoy lower monthly payments, that benefit may be offset by a higher lifetime borrowing cost.
Some loans offer useful features that lapse if the loan is refinanced. For example, federal student loans offer more flexibility than private student loans, providing protection if borrowers fall on hard times.
Refinancing offers a number of key benefits, but borrowers need to weigh up the pros and cons of specific loan terms to identify the best deal for them, considering overall interest repayments both in the short and long-term.
About Kevin NealKevin Neal is a former IFA with extensive knowledge of the finance industry. As Distribution Director of Bluefin Capital (Luxembourg), Mr Neal is responsible for distributing more than 500 million in capital predominantly raised through European, Far Eastern, and Middle Eastern markets.