Even for the most financially literate, understanding mortgages and other loans can be a bit of a challenge. Add in the option to refinance your loan, and you may be feeling totally thrown for a loop. That’s why we’re breaking down what it really means to refinance and when you may consider the option.
What is refinancing?
In the simplest terms, refinancing is when you take out a new loan at a different interest rate and use those funds to pay off your existing loan. Commonly referred to as a “refi,” refinancing allows you to review and revise some of the terms, like the interest rate or your repayment schedule. Depending on the institution and loan type, you may be able to refinance your loan with the original institution, but you may also consider a new lender.
How does refinancing work?
You’ve likely heard about refinancing in terms of your mortgage or auto loan, but you can also refinance other loans, including student loans and credit cards. Because there are variety of loans that can be refinanced, there are also a variety of options for how you may want to refinance your loan.
Rate-and-term
The most common type of refi is rate-and-term financing. Exactly like the name suggests, this type of refi replaces your original loan with a better rate or term. In some situations, you’ll want to refinance for a better interest rate and to lower your monthly payments. However, you can also use this kind of refi to change your repayment schedule—if you’ve been paying off a 30-year mortgage for a decade, refinancing for 15 years may be preferable instead. Rate-and-term refinances typically occur after mortgage rates have dipped.
Cash-out Refinancing
Another type of refinance is a cash-out refi. Let’s say your house has increased significantly in value—instead of selling it, a cash-out refi lets you exchange your home’s equity for cash, while still maintaining ownership. With a cash-out refi, you would use your home as collateral for a new loan, creating a new mortgage for an increased amount, with the difference paid out to you directly.
Cash-in Refinancing
You may also consider a refinance if you’re looking to pay down some of your debt and you have a bit of money saved up already. In this case, you might consider a cash-in refinance, where you replace your current loan with a smaller one by making a lump-sum payment. With this payment, your principal balance decreases, which lowers your monthly payments.
Consolidation
As mentioned above, you also have the option to refinance student loans or credit card debt, which you can do with a consolidation. In this case, your loans are combined into one single loan at a rate that is lower than your current average rate. If you have several student loans for different degrees, or a lot of credit card debt, this may be a good option. Consolidation refinancing can also be used in situations where you may have accrued medical debt due to an unforeseen incident.
When should you refinance?
As with most financial decisions, refinancing is a personal choice. There are plenty of benefits to refinancing—but as with all things, there can be downsides.
Of course, one of the biggest potential benefits is lowering your monthly payment or interest rate. Interest rates for home purchases right now are higher than they’ve been in decades, so you may be considering a refinance when interest rates drop. If so, you’ll see this reflected in the interest portion of your payment, which would be much smaller, or an overall shorter loan duration.
You can also refinance if you’re trying to lower your monthly payment, even if you’re not reducing your interest rate. In this scenario, you’d extend your loan period, while decreasing your monthly payments. While you may end up paying more over time, the lowered payments may provide you with a little financial relief. And of course, you can also refinance a loan for a shorter period of time, saving you money on the total interest paid.
Another type of refi involves converting from an adjustable interest rate to a fixed interest rate. Fixed interest rates afford you much more predictability, but could cost you savings—you won’t reap any benefits if interest rates drop unless you refinance again.
Refinancing could end up costing you more money overall. As mentioned above, refinancing for lower monthly payments may end up increasing how much you’re paying in total. Additionally, if you reset your loan term to its original length, the total interest you’ll end up paying may outweigh any savings. When refinancing for a reduced loan term, your monthly payment increases, and you’ll have to pay closing costs on the refinance. Lastly, refinancing could potentially lower your equity on the house.
I’d also like to offer my personal perspective. At the end of 2023, I found the perfect house for me. Unfortunately, inflation caused the rates to be less competitive, but I couldn’t pass up the opportunity—I’d been commuting nearly two hours one-way for over a year, and the house was close to work with the perfect yard for my pets and my garden. While I’m not ready yet, I know that refinancing at some point will be a good option for me to get a lower interest rate and decrease my monthly payments.
Key takeaways:
- Refinancing replaces your existing loan with a new loan at a different interest rate.
- You can refinance many types of loans, including mortgages, auto loans, student loans, and credit card debt.
- Refinancing is a good option if you want to lower your monthly payment, your interest rate, or your loan term, or a combination.
Overall, refinancing can be a good option if you’re looking to lower your monthly payments, lower your interest rate, or pay off your loan sooner. Refinancing can also help you deal with debt like student loans, credit cards, or medical debt.
Still have questions? Our mortgage loan officers can help you navigate your next move, or check out our personal and auto loan rates to see if refinancing could save you money. Have you ever refinanced a loan? Tell us about it in the comments!
