What Does it Mean to Refinance a Loan?

What Does Refinance Mean

Wouldn’t it be something if life handed out do-overs? Just envision all those regrets or lost chances you’d jump on. Like coming up with a perfect zinger five minutes too late or the time you ordered a spicy meal that gave you heartburn all night long. 

Well, one of the nearest things to a do-over in life comes from the finance world: refinancing a loan. Refinancing is when you replace your old loan, often a mortgage, with a brand-new one that can save you money, lower your payments, and provide you with much-needed funds, among other benefits.

Refinancing a loan means replacing your current loan with a new one, often to gain access to extra cash or take advantage of better terms.

I’ll guide you through some key issues with refinancing a loan, including different strategies, the steps involved, and reasons you may want to consider refinancing. You won’t regret taking the time to understand this beneficial financial tool!

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How Refinancing Works

It’s a good idea to know how refinancing works and what types of loans you can swap out. If you have no idea, chances are you’re missing an opportunity to save a bunch of money or get yourself out of a financial jam. 

Think of it as learning to drive a big truck before getting behind the wheel — it’s better to understand what you’re doing before you get into a fender bender right away.

The Basic Concept

Refinancing lets you replace your current debt with something new and fresh, hopefully with better terms. If you can snag a new loan with a lower interest rate, smaller monthly payments, or more time to repay, then you’ll have something to celebrate. 

The new loan pays off the debt, and then you’re back in the business of making payments, only this time with things working more in your favor. You may save money every month or possibly pay the debt off sooner.

But don’t go jumping in heedlessly — refinancing doesn’t fit every situation. You’ve got to make sure you’re getting a deal that’ll actually be helpful, either immediately or in the long run.

Types of Loans Eligible for Refinancing

Let’s talk about the kinds of loans you can refinance. Just about any loan you can think of can be refinanced if the time’s right. Here’s a rundown of some of the big ones:

Mortgages

Mortgages are probably the granddaddy of all refinancing. If you can get a lower interest rate or switch up your loan type, it could save you thousands or maybe even tens of thousands over the life of the loan.

mortgages graphic

For example, you may replace an adjustable-rate mortgage with a fixed-rate one when the balloon payment comes due. 

Or you might get a cheaper mortgage if interest rates fall. Be sure to factor in the new loan’s closing costs when figuring out your savings.

Refinancing could also put money back into your pocket through cash-out refinancing. This could help with home renovations or paying off debt, but understand that you may be adding years to your mortgage, so weigh the benefits and drawbacks carefully.

Auto Loans

Got an automobile loan that’s weighing you down? Well, if your credit rating has improved since you drove that car off the lot, then refinancing could lower your monthly payments, giving you some much-needed breathing room. 

auto loans graphic

Or you may want to monetize some of the equity you’ve built up (i.e., the car’s current value minus your loan balance) through a cash-out refinancing. 

It’s handy if you need quick money, but remember, like with a mortgage, you may be taking on more debt, so don’t go hog wild unless you’re absolutely sure you can manage it. But be sure to watch out for common scams.

Student Loans

If you’re lugging around a mountain of student debt, refinancing might help whittle it down to size. Maybe you’ve landed a better job, or your credit’s looking a little brighter.

student loan graphic

Either way, you could trade that high interest rate for something that won’t empty your wallet every month. 

Now, if you have a bunch of student loans, you may want to bundle them into one with a single monthly payment. Federal Direct Consolidation Loans are available for this purpose. 

They charge an interest rate equal to the average rates of your other student loans. By stretching the loan term, you could reduce your monthly payout. But heads up: You’ll also increase your interest cost over the long haul.

The Refinancing Process

If you’re ready to hitch your wagon to refinancing, I can tell you how that would take place, step by step.

  1. Application: You have to find lenders willing to take on your refinancing. They will want information regarding your income, credit score, and details about your current loan. Think of it like courting: You have to make them believe you are worth it before they say yes.
  1. Credit Check: A lender is going to check your credit to make sure you’re a reliable person who pays their debts. The better the score, the better the deal they can offer you. You may be in for a treat if your credit is looking sharp!
  1. Loan Offer: Once you’ve cleared the credit check, the lender will offer you a loan. This will include the interest rate, loan term, and any fees you’ll have to pay. Go over the offer with a fine-tooth comb and read all the fine print. This way, you can make sure you are getting a deal that will work in your favor.
  1. Approval and Funding: If you like what you see, you can sign on the dotted line. From there, the lender pays off the old loan. Now, you’ll be starting fresh with the new loan and can expect smoother sailing from here on out. You’ll be making payments on this new loan with a bit more cash in your pocket or lower monthly payments.

Why Consider Refinancing?

If you are scratching your head about why you would go through all the trouble of refinancing, here are the simple reasons: It could save you some serious money, give you access to fast cash, or make your monthly bills easier to manage. 

Knowing about these options will help you decide whether taking the plunge is really worth the work.

Possible Lower Interest Rates

Refinancing is one of the most popular ways to snag a lower interest rate, potentially saving a pretty penny over the life of the loan. You may lock in a lower APR if the interest rates have fallen since you took out your loan, or maybe your credit score is looking better these days. You are trading in your old loan for a sleeker and cheaper model. Less interest means more money in your pocket.

refinancing to save on interest graphic

Now, suppose that you have been halfway through paying off a $20,000 car loan at 6% interest over five years. You have been shelling out $386 a month for 2.5 years, and so far, you have paid about $11,604. You still owe about $10,420 on the loan. Without refinancing, your total cost will be $23,159.

If you refinance at this point to a 4% interest rate for the remaining 2.5 years, your new payment drops to $365 a month. You’ll have parted with $22,560 by the time this loan is done. That’s like paying yourself $599 — not too shabby!

Access to Cash

As I mentioned earlier, another reason people refinance is to get some cash. It is called cash-out refinancing. You take out a new loan, larger than what you still owe on your old loan, and you pocket the difference. The extra cash gets tacked onto your new loan, and you’ll pay it back with interest.

If you need extra funds, a cash-out refinancing loan could land you some needed cash based on the equity you have built up in your home.

For example, let’s say you have $10,000 left on your car loan, but the car is worth $15,000. You could refinance for $12,000, pay off the $10,000, and walk away with $2,000 cash in hand. Just be sure you’re not getting in over your head — cashing out now means more debt to manage later.

Potential for Reduced Monthly Payments 

Refinancing can also lower your monthly payments, giving you some breathing room if you’re feeling squeezed. You can shrink those payments and make bills a lot easier to cover by stretching out the length of your loan or snagging a lower interest rate.

For example, suppose you have a $15,000 loan at 7% interest over three years. You’re paying $463 a month, which can be a pretty heavy load. But if you were to refinance into a five-year loan at 5%, your payments would slip down to $283, for a monthly savings of $180. 

Even though you pay more in total interest over the life of the loan, it’s worth doing if you need a little financial wiggle room.

Changing Your Loan Terms

Refinancing isn’t just about rates and payments. You may be able to adjust the length of time you have to repay your loan so that it matches up with your financial goals. 

Want to pay off some debt? Consider refinancing into a short-term loan and knock that debt down like a heavyweight boxer. Just remember, your payments will be higher, but it may save a ton of interest in the long run.

refinancing to pay off debt graphic

If you want to lighten the load of those monthly payments, you can extend that loan term. You’ll pay more in interest over time, but it may keep you from drowning in monthly bills. You have the flexibility to shape your loan either way by speeding things up or slowing them down.

For example, refinancing a five-year, $25,000 loan at 5% to a three-year term at 4% would increase your monthly payment despite the lower interest rate. On the plus side, you’ll pay off the loan quicker and save money on interest.

Benefits and Drawbacks of Refinancing

Sure, refinancing does bring a lot of good. Still, as with everything in life, it has its flip side. Let’s weigh those pros and cons so that you may see whether refinancing is worth jumping in with both boots.

Benefits

  • Potential Cost Savings: Refinancing can reduce your interest costs significantly, thus saving you money over the life of the loan. It’s like getting a discount on your debt.
  • Improved Cash Flow: Lowering your monthly payments also frees up some extra cash every month, like finding a $20 bill in your old jacket pocket.
  • Debt Consolidation Opportunities: Do you have multiple loans nagging you? Refinancing can allow you to bundle these together, making them easier to manage with only one monthly payment to deal with.
  • Potential Positive Credit Score Impact: If you’re able to cut your balance down and continue to make timely payments, refinancing might help boost your credit score in the process — that is a terrific bonus.

Drawbacks 

  • Closing Costs and Fees: Refinancing isn’t free. There could be some closing costs and fees tacked on that can add up to more than your savings.
  • Extending Loan Terms: Stretching your loan might reduce your repayments, but in the long term, the negative side is paying more interest, which is like dragging out a chore rather than doing it now and getting it over with.
  • Impact on Credit Score: Refinancing typically involves a hard credit inquiry, slicing a few points off your score, at least in the short term.

Refinancing can give you some breathing room, but you should consider the costs and benefits before taking the plunge. Please take a good, hard look at your situation and make sure it’s the right move before saddling up.

Common Alternatives to Refinancing

Refinancing isn’t the only game in town, and it’s good to know about the other ways you can tackle your debts without swapping out your loan. When refinancing doesn’t quite fit your unique situation, maybe one of these will.

Loan Modifications

Suppose you’re struggling to keep up with your loan payments and don’t fancy refinancing. In that case, a loan modification might be worth considering. With a loan modification, you and your lender agree to make changes to the terms of your existing loan. 

These may include lowering the interest rate, extending the term, and so forth to make it more affordable. 

Loan modifications could give you the short-term breathing room you need without having to go through a lengthy refinancing process.

It’s like asking for a little more slack in the rope when things get too tight. This is useful if you’re going through financially hard times, such as the loss of a job or a serious decline in income. 

Instead of starting over with a new loan, you keep the one you have, but its terms get modified so that you gain some breathing room. It’s like patching a leaky roof instead of replacing it.

Home Equity Loans or Lines of Credit (HELOCs) 

Suppose you are a homeowner who needs to tap into the value of your home without refinancing. In that case, you may want to consider a home equity loan or a line of credit.

A home equity loan is like a second mortgage, borrowing against the equity you built up in your home and, in return, you get an immediate big lump sum. 

A HELOC works more like a secured credit card: You can borrow as much or as little as you need up to a pre-set limit based on your equity. In either case, you’re using the value of your home as collateral. That means if you fail to make payments on the money you borrow, you could risk losing your home.

HELOC flexibility graphic

A HELOC is much more flexible because chances are, you may not need the entire amount of money all at once. You can occasionally dip in and take out what you need at the time, paying interest only on the cash you use. 

This works very well if you need a little money today and some more in the future. Kind of like having a well you can draw from whenever you’re parched.

Know When Loan Refinancing Makes Financial Sense

Refinancing can be a brilliant way to grab lower interest rates or cut your monthly payments and help you stay afloat. 

But don’t jump in without checking the fees and extra years that can cost you more. Weigh the benefits, keep the calculator handy, and you will know if refinancing is the right move.