What Does Refinance Mean?
Refinancing simply refers to the process of revising and replacing the terms of an existing credit agreement. The most common types of refinances are car loans and mortgages.
When you refinance a loan, you’re looking to get a better interest rate, payment schedule, or terms. Borrowers typically choose to refinance when the financial environment changes and interest rates drop significantly.
If you have a loan at a rate that’s substantially higher than current market rates, refinancing your loan might make sense.
Keep reading to learn more or click on a topic below:
- Reasons to refinance
- How refinancing works
- Common refinancing options
- Types of loans you can refinance
- Pros and cons of refinancing
Reasons to refinance
Most people refinance a loan to get better terms and conditions. These could include:
- Getting a lower interest rate
- Reducing monthly payments over the life of the loan
- Changing the length of the loan
- Switching from a fixed-rate mortgage to an adjustable-rate mortgage (ARM), or vice-versa
You might also want to refinance because your credit score has improved, when there are changes in your long-term financial plans, or to consolidate high-interest debt into one low-priced loan.
If you have a variable-rate loan and interest rates are on the rise, you might want to consider refinancing to a fixed-rate loan at the current market conditions. Alternatively, if you have a fixed-rate loan and interest rates are falling, you might want to refinance to reduce the amount you’ll pay in interest over the life of the loan.
How refinancing works
Since you’ve already gone through the loan approval process once, most of the refinance process will look familiar.
To refinance your loan, the lender first request that you complete a new loan application. They’ll re-evaluate your credit score and financial situation.
Some of the most common types of refinances on consumer loans are:
- Car loans
- Student loans
Common refinancing options
You have several types of options when refinancing a loan. The option you choose depends on your specific financial needs.
Common refinancing options include:
- Rate-and-term refinancing. This is probably the most common type of refinancing. Rate-and-term refinancing is when the original loan is replaced with a new loan agreement that includes lower interest payments.
- Cash-out refinancing. Cash-out refinancing is common when the asset used for collateral in the loan (your car or house, for example) has increased in value. It involves withdrawing some of the value, or equity, in exchange for a higher loan amount. This sometimes means a higher interest rate, though. A cash-out refinance increases the total loan amount and lets you maintain ownership of the asset.
- Cash-in refinancing. A cash-in refinance lets you pay down some of the loan. This will give you a lower loan-to-value ratio and/or smaller loan payments.
- Consolidation refinancing. A consolidation refinance can be a good way to pay off high-interest loans from multiple sources. Instead of making multiple payments each month, you can consolidate at a lower rate and focus on paying off that one loan. Consolidation refinancing also refers to refinancing a single, high-interest loan for a new loan at a lower interest rate.
Types of loans you can refinance
Here are the most common types of loans you can refinance:
Student loan refinancing is usually used to consolidate multiple loans into one payment. For example, you might have student loan debt that includes private loans, subsidized federal loans, and unsubsidized federal loans. Each of these loan types might have different interest rates and are likely serviced by different companies. By refinancing your student loans, you can pay off your debt through one lender, and possibly get a better interest rate.
Using a personal loan to refinance credit card debt is a pretty common strategy. Since interest accrues quickly on an outstanding credit card balance, it can be hard to keep the debt under control. In addition, credit card rates tend to be higher than personal loan rates. Paying off your credit card balances with a personal loan can give you a more affordable and manageable way to pay off your debt.
Homeowners typically choose to refinance their mortgages for two main reasons:
- To lower their monthly payment
- Shorten their term length from 30 years to 15 years
For example, if you financed your home purchase with an FHA mortgage, you are required to pay more mortgage insurance than a homeowner with a conventional mortgage, who only has to pay insurance until 20% equity is reached. However, if you’ve hit the 20% equity mark, you could refinance into a conventional mortgage and stop paying mortgage insurance altogether.
Some mortgage holders refinance to switch to a 15-year mortgage in order to pay down their home loan quicker. If you can afford to make a larger monthly payment, a shorter term on your home loan could save you a lot of money in the long run. Interest rates are lower on shorter term loans and it won’t be accruing for as long.
If you’re considering refinancing your mortgage, you’ll want to think about all of the costs involved. Some of these, like appraisal and closing costs, can be quite high. Refinancing your mortgage to save a few hundred dollars each month might not be worth the time and money it takes to get a new home loan.
Car owners choose to refinance their auto loan to get lower monthly payments. If you’re in danger of defaulting, refinancing and restructuring your loan agreement could help you get your finances back on track. Lenders usually have some eligibility requirements for refinancing a car loan. These could include:
- The age of the car
- Mileage caps
- Outstanding balance limits
Pros and cons of refinancing
- You can get a lower monthly payment and interest rate
- Convert an adjustable rate to a fixed rate, which gives you predictability and possible savings
- Get a shorter loan term, allowing you to save on the total interest paid
- If your term is reset to its original length, your total interest payments over the life of the loan might be greater than what you save at the lower rate
- If interest rates drop after you refinanced to a fixed-rate loan, you’ll have to refinance again
- You may reduce the equity in your home
- Your monthly payment increases with a shorter term loan
Refinancing a loan is a common practice when interest rates drop or financial situations change. Most people refinance their loans to get a lower interest rate, shorter terms, and lower monthly payments.
Refinancing makes sense in certain situations but might not be worth the time and effort in others. Make sure you understand how much you’ll actually save in the long run and that you can afford the higher payments if you’re refinancing to a shorter term.
If you have questions about loans, check out the other articles in the Loans section of our Learning Center.