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Complete Guide to Loan Refinancing
If you are unsure what refinancing a loan means, it is difficult to understand whether it is a good choice. Refinancing is a powerful financial tool, but it is important to know how, and when to use it correctly. Read on to learn more about loan refinancing.
What is Refinancing?
Loan refinancing is the process of taking out a new loan to pay off one or more existing loans. Refinancing is often used to take advantage of better loan terms available in the present than when the older loans were taken out. Many different kinds of loans can be refinanced. A few refinancing scenarios are discussed below.
Refinancing Auto Loans
Refinancing a car loan is often used to lower the monthly payments. Refinancing is a way to pay less per month in exchange for extending the life of the loan. Lenders often have specific requirements for refinancing, such as:
- your credit score,
- the outstanding balance on your loan
- age and mileage of your car.
Refinancing Credit Cards
Interest on outstanding credit card debt often accrues quickly. Refinancing credit card debt can be a way to limit the cost by refinancing it as, for example, a personal loan with a lower, predictable interest rate.
Mortgages are some of the longest-term loans in normal life. Refinancing can be a way to shorten or extend the repayment period of a mortgage. This can substantially decrease the total cost of the mortgage or decrease the monthly payment respectively.
Refinancing a mortgage can also be a way to take advantage of a better interest rate than you originally got. For example, if you originally got a 30-year mortgage at 8% interest, you might decide to refinance at a 4% rate.
Refinancing Small Business Loans
Debt is a leading cause of small business failure. Refinancing small business loans can be a way to manage the monthly lending costs your business has to cover. Refinancing small business loans can be done with a variety of collateral types, including:
- receivables (money owed to your business).
Refinancing Student Loans
Refinancing is often used to consolidate (combine) several different student loans into one. This can simplify your expenses because you pay one lender instead of several.
Keep in mind that refinancing a federal student loan means you lose the benefits such as loan forbearance, payment holidays, and forgiveness.
Also, private student loans usually charge much higher interest than federal ones. In other words, refinancing federal student loans is unlikely to save you any money.
How to Refinance a Loan
If you decide that refinancing one or more of your loans is right for you, there are several steps you will need to take. The refinancing process differs depending on the lender for the new loan and the nature of the old loans, but the steps listed below apply generally.
- Compare: You could save a lot of money by not paying fees such as pre-payment and loan origination fees. Compare offerings from many different lenders to find the best.
- Check: The Better Business Bureau has reviews from customers of many different businesses. Before you commit to a refinancing lender, make sure they have a good reputation.
- Credit: Your credit score is often the main thing that will determine whether your refinancing application will be successful or not. Check your credit score before applying so you know where you stand.
- Fees: Make sure you understand what fees you will have to pay. Avoid lenders that are often accused of having hidden fees.
- Prequalify: Prequalification is a way to check if your application will be rejected without a ‘hard’ credit check, which decreases your credit score.
- Apply: If everything looks good, you can submit a formal application. The lender will submit a ‘hard’ credit check, but the negative effect of it will be canceled out as you pay off the refinancing loan.
How to Know If You Should Refinance a Loan
Even when you understand what refinancing a loan means, it can be difficult to understand if it is the right thing for you. Consider the factors below when deciding whether to refinance a loan or not.
- Interest: If your credit score has improved since taking out the original loan, you might be able to refinance at a much lower interest rate. If the loan is large and long-term, refinancing at a lower interest rate could save you hundreds or even thousands of dollars in interest payments.
- Repayments: Although you can pay more than the minimum monthly payment, you must never pay less. If you can no longer keep up with the payment schedule, refinancing can be a way to pay less per month for a longer time.
- Term: On the other hand, if you can afford higher payments, refinancing can allow you to dramatically shorten the loan term, by paying more per month. This can result in major savings on the interest that would have accrued over the longer repayment period.
Can Refinancing Hurt Your Credit Score?
When you understand what refinancing a loan mean, you might next wonder if it can decrease your credit score. The answer is not straightforward, but the considerations listed below will help you understand.
- Credit: Whenever you formally apply for a loan, the lender submits a hard credit check, which causes a slight drop in your credit score. If you shop around with multiple lenders that do a hard check, make sure they all happen within a 14-day window of each other. Then the effect of the checks will be minimized.
- Age: Some credit reporting bureaus use credit score models that will cause a decrease in your score if you close an old loan and decrease the overall age of your credit mix. This is not universal, however.
- Newness: If you have several different new loans or other credit products, some credit scoring models may decrease your credit score.
Note that all of the effects listed above will eventually be outweighed by the positive effect of sticking to your refinancing loan’s payment schedule.
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When understanding what does refinancing a loan mean, it is also important to understand how to refinance and when it is a good idea. Refinancing is taking out a loan to pay off one or more existing ones. It can be used to lower the interest rate, decrease monthly payments, or decrease the total interest accrued. Refinancing can also be used to simplify repayments, also called consolidation. Refinancing can slightly decrease your credit score but the effect will be outweighed by the effect of sticking to the payment schedule.
Keep in mind that refinancing isn’t always a good idea. Our resident financial expert, Rohit Mittal, discusses the times when refinancing student loans is a bad idea in this post.