One day you wake up in the morning, check your household bills, and decide that your loans are just too expensive. Your next thought? What to do about that problem.
That's where refinancing enters the picture.
Refinancing a major loan - think mortgages, student loans and auto loans, for starters - allows you to gain a new loan at a reduced interest rate, which saves you money on your monthly payment and can curb the total amount of the loan.
Many Americans have had the same thought, and may well refinance into a new loan, if interest rates are low enough.
Case in point: In early 2019, mortgage interest rates have dropped to their lowest levels in nine months, to approximately 4.5% in January. That decline translates into a $90-per-month savings on a $300,000 mortgage, according to data from Freddie Mac.
That figure explains why consumer mortgage refinancing rates rose by 35% in early January, as homeowners flocked to take advantage of lower interest rates, and lower monthly mortgage loan payments.
What Is Loan Refinancing?
Loan refinancing isn't all about mortgage loans, although mortgage refinancing is the most common form of refinancing.
Student loans, business loans, auto loans, and pretty much any large loan can be refinanced if the borrower deems the loan too expensive, and sees an opportunity to recast the loan into a smaller amount when interest rates are low.
Basically, refinancing turns a larger loan amount into a smaller, more financially manageable loan payment. The refinanced loan pays off the old loan with the higher rate. Ideally, the newly-refinanced loan has not only a lower interest rate, but should also come with lower or no fees and better terms.
There are some caveats to refinancing loans.
For example, individuals struggling with debt payments often refinance into loans with longer repayment timetables, in exchange for lower interest rates. In this case of refinancing, those borrowers will pay more over the course of the loan, as the length of the repayment is extended.
Are Lower Payments the Goal of Refinancing?
That's not what we're talking about here.
In the traditional definition of refinancing, the idea is to lower those monthly payments without extending the loan repayment timetable. That ensures a lower monthly interest rate, but doesn't boost the overall cost of the loan.
Let's say a homeowner who took out a mortgage loan in 2005 with a mortgage rate of 6.5%, takes out a refinanced mortgage loan in 2019 with an interest rate of 4.0%.
With the new loan, that borrower can easily turn a monthly mortgage payment of $2,000 into a monthly mortgage of $1,500 - making life a lot easier for the homeowner.
Think about it - the mortgage holder could either take the $500 in savings each month and stash it away for retirement, or keep paying the $2,000 monthly mortgage and accelerate the mortgage loan paydown and pay off the home much more quickly.
That's the very definition of a win-win from a personal financial point of view, and represents the high demand for loan refinancing in periods of low-interest rates.
Different Categories of Loan Refinancing
While mortgage loans represent the lion's share of refinancing loans, there are other large loan categories where refinancing can lower costs. Let's take a look at the major loans that can lead to a refinancing deal:
1. Mortgage Loans
Mortgage loans are the largest refinancing loan category. Mortgage borrowers may have hundreds of thousands of dollars tied up in a home purchase, so any cut in interest rates can translate into big savings for homeowners.
Mortgage refinancers need to be careful, though. In many mortgage refinancing cases, lenders require upfront closing costs. Such costs may include credit fees, appraisal fees, points, insurance and taxes, escrow and title fees, and mortgage lender fees.
These fees can add up. For instance, a mortgage borrower who refinances a $200,000 30-year-fixed mortgage and even has a solid credit score can expect to pay between $3,000 and $5,000 in total closing costs, either upfront or spread out over the term of the loan.
A good mortgage refinancing calculator can tell you exactly how much you'll save on a refinancing deal, factoring in the loan's closing costs.
2. Student Loans
With the total amount of student loans in the U.S. cresting $1.2 trillion in 2018 (that's about $29,400 per borrower) student loan refinancing deals are increasingly becoming a "go to" option for struggling borrowers.
There are various factors in play with student loan refinancing. In many cases, for example, refinancing multiple loans into a single, larger loan with a lower interest rate is the borrower's primary goal.
It's actually not too common to see a college loan borrower try to refinance strictly to get a lower rate, given the fact that the borrower is likely young, may not have good credit, and the loan amount is low enough where the refinanced loan makes a big difference in terms of lower monthly payments.
3. Credit Card Debt
Consumers who see their credit card debt spiral out of control may turn to refinancing to get that debt under control. But again, the model card borrowers use to refinance isn't similar to what a mortgage borrower may do to refinance a $350,000 home loan.
With credit cards, borrowers are more likely to refinance using a smaller personal loan to cover, for example, $20,000 in credit card debt.
Since most credit cards come with higher interest rates than personal loans, it could be wise to take out a personal loan to cover excessive credit card debt, or even better to manage credit card debt among multiple credit cards by turning (or consolidating) into a single household loan dedicated to eliminating credit card debt.
4. Auto Loans
It's more difficult to successfully refinance an auto loan, even though it does happen and for the same reasons a mortgage holder wants to refinance - to cut monthly payments. The problem is, banks and lenders have stricter loan standards with auto loans, as vehicles are more vulnerable to damage, wear and tear, and outright destruction than the average home.
Consequently, banks may well stick auto loan refinancers with onerous eligibility requirements to refinance an auto loan, including putting age requirements on cars, trucks and SUVs, limiting mileage caps, and taking a harder look at credit score and outstanding loan balance factors.
The better bet for auto owners in financial distress is to work directly with your auto loan provider, who doesn't want to see you default on the loan, and will likely work with you to ease the loan burden.
5. Small Business Loans
Entrepreneurs and start-up business owners often turn to refinancing to lower business costs.
Uncle Sam makes that easier for small company owners, especially with U.S. Small Business Administration 504 loans, which are the Swiss army knife of business loans. Not only do 504 loans help companies buy equipment and office space, they're also widely used to refinance small business loan costs, and lower monthly payments.
Four Refinancing Tips You Need To Know
Whether you're refinancing a mortgage loan or looking to cut your auto loan costs, there are some basic blueprint-worthy steps to take to make the process easier, and improve your refinancing loan experience.
1. Do Your Prep Work
Don't leap headfirst into a refinancing deal just because an interest rate seems low. Banks and lenders often attach financial detonators to refinance loans, such as high closing costs, prepayment penalties, huge late payment fees that also include an automatic interest rate hike on the loan.
These fees and penalties can negate any savings you're getting from the new loan and may even lead to credit score troubles if enough late payments mount up.
2. You Might Lose Some Perks
Rushing headlong into a loan deal may have long-term repercussions you haven't counted on. Take student loans, which usually start out as federal-backed student loans when you first got them back in your college days.
When you refinance a student loan, you're refinancing out of a federal government loan and into a private loan. In doing so, you're losing perks and benefits that come with federal student loans, like more flexible payment terms, the ability to defer or apply an income-based formula to a loan, and public service student loan payoff-based opportunities.
3. Take Advantage of a Better Credit Score
If you're emerging from a financial struggle, and your credit score improves as a result, look into refinancing high-interest loans you were forced to take when your credit was toxic.
Your newer, stronger credit score can qualify you for a refinanced loan with lower regular payments, thereby cutting your loans costs, giving you more financial leverage and making it easier to pay down those loans, and further boost your credit score.
4. Add Value to Your Home
If you're a homeowner in an advantageous financial position, i.e., you owe $150,000 on a home worth $450,000, you can take a cash-out refinance loan - you refinance into a loan worth $175,000, pay off the remaining $150,000 mortgage, and use the extra $25,000 to "beautify" your home with a new paint job, a new roof, and a remodeled bathroom or two, adding more value to your home.
Refinancing Has Its Risks and Rewards
Like any big personal financial move, a refinanced loan has it its upsides and downsides, and it's up to you take the measure of all of them and decide whether moving on to a refinancing deal makes sense for you.
If you do so, and you're still not sure, talk to a trusted financial adviser or bank lender and run through the risks and realities of taking out a refinanced loan - and then act accordingly, in your own best financial interests.