Have you ever considered how lenders compare applicants? Typically, the lowest rate goes to those who have the highest likelihood of repaying the loan on time. A lot of data goes into determining that probability, including the person’s credit, income and outstanding debt.
As these factors improve, the terms on new loans might improve as well. It is possible to refinance debts taken on earlier in life and take advantage of changes. As a result, a borrower might be able to decrease their interest rate, lower their monthly payment and save a lot of money.
Refinancing, which is often done by taking out a new loan to pay off existing debt, can be surprisingly simple. In some cases, a borrower can submit all the information online, and the entire borrowing process will only take a few days. However, refinancing more complex debts, such as a mortgage, can take considerably longer.
While refinancing doesn’t always make sense, it’s worth considering if a borrower is in one of the following situations.
Interest rates have dropped. Some loans’ interest rates depend on a benchmark interest rate, such as the London Interbank Offered Rate. Even if the financial profile stays the same, when the benchmark rate rises or falls, the interest rate on a new loan could rise or fall as well.
The borrower wants to change the terms of their loan. Because they’re taking out a new loan to pay off existing debt, they might have the opportunity to change the terms of the loan. For example, they could have a variable-rate student loan whose interest rate rises or falls with a benchmark. They might be able to refinance with a fixed-rate student loan and have certainty that the monthly payments won’t change in the future.
If the borrower has a lower interest rate after refinancing and have the same amount of time to repay the loan or perhaps less time, they can save money over the lifetime of the loan.
The borrower wants to lower their monthly payments. Say they have a 30-year mortgage that they’ve been paying off for five years. If they refinance with another 30-year mortgage, they have an extra five years to pay off approximately the same amount of money. As a result, the monthly payments could be lower, but they should take into consideration the fact that they will likely wind up paying more in interest.
The loan has a co-signer. Perhaps the borrower asked someone to co-sign an auto loan to improve their chances of getting approved or of getting a lower interest rate. If they are now eligible, refinancing on their own might release the co-signer and allow the borrower to take full responsibility for the new loan.
Borrowers should proceed carefully because applying for refinancing could hurt their credit. Applying for refinancing often results in a hard inquiry, when a potential lender reviews the borrower’s credit. Generally, a single hard inquiry won’t have a large negative impact on credit, but multiple hard inquiries might.
When refinancing a mortgage, auto loan or student loans, shop around and try to find the best rate without worrying about credit too much. As long as the hard inquiries happen within a 14- to 45-day period, depending on the credit-scoring model, the credit-scoring model will consider them a single inquiry.
Consider the fees and find the break-even point before refinancing. Depending on the type of debt and the lender, there could be costs associated with refinancing debt. For example, some loans have an origination fee, either a flat fee or a percentage of the loan amount, which could be significant.
The break-even point is how long it’ll take to recoup the costs associated with refinancing. For example, it could cost $3,000 to refinance a mortgage, but the borrower will save $150 each month. They’ll break-even after 20 months because that’s when they’ll have saved $3,000 in monthly payments. If they plan on selling the home before the break-even point, it doesn’t make sense to refinance.
Use the same sort of calculations to weigh the pros and cons of refinancing other types of debts. When it looks like refinancing could be beneficial, borrowers should shop around to try and find the terms that best fit their needs.
Nathaniel Sillin directs Visa’s financial education programs. To follow Practical Money Skills on Twitter, visit www.twitter.com/PracticalMoney.