No one likes debt, but unfortunately, some debt is practically unavoidable. Consumers may find that they need an auto loan, a mortgage, or even a personal loan to consolidate credit card debt or to deal with unforeseen circumstances. If loans become necessary, at some point, it might be a good idea to refinance. For a consumer, one of the most important aspects of having a good financial life is to better manage debt — but refinancing a loan can actually hurt someone’s credit. There are also many other benefits and drawbacks.
What Does it Mean to Refinance a Loan?
To understand the pros and cons of refinancing a loan, we first need to look at what refinancing means. To put it simply, when a borrower refinances a loan, they get a new one, use it to pay off the original one, and then have a new loan with new terms. Refinancing can also be helpful when a consumer wants to consolidate multiple credit cards or loans into one payment.
There are several different types of loans that someone may want to refinance, such as:
- A mortgage
- An auto loan
- A personal loan
- Student loans
- Credit card balances
What Are the Pros and Cons of Refinancing a Loan?
Before a person decides whether to refinance a loan, they first need to have a comprehensive understanding of the pros and cons of refinancing a car loan, a mortgage, or a personal loan.
1. Pro: It can lower the monthly payments.
One reason refinancing is so appealing to some is that it can reduce monthly payments. This can really help for those who are struggling to make these payments, especially if they’re experiencing financial hardship
When someone refinances for a loan with a lower interest rate, this can decrease monthly payments. To see a much lower payment, however, a borrower would need to extend the time to repay the loan, which may mean a higher amount of interest paid over time. This can really help to improve a person’s overall cash flow every month, which is a great way to achieve the goal of having a better financial life.
2. Pro: It can help a consumer to pay a loan off sooner.
A person may have more income than they had when they first purchased the car or home or took out the personal loan. In this case, it may be beneficial for them to refinance their loan for a shorter amount of time so that they can pay it off sooner.
If a consumer pays the loan off sooner, they may wind up paying less in interest overall. Nothing will help someone’s monthly cash flow like having one less payment to make.
3. Pro: Tapping into a car or home’s equity can be a great way to get some extra cash.
Let’s say a car is worth $17,000 and the consumer owes $12,000 on it. They could refinance the car loan using the car’s equity to get a $17,000 loan, and then they would be able to keep $5,000 of that. This is also how it works with a home loan if you have equity in your home.
However, this option comes with some risks. There is more of a risk of foreclosure, for example, if the homeowner cannot repay their loan. It can also increase overall interest costs. It’s a good idea to do this if the extra money is used for education needs, home improvements, or anything else that can improve someone’s financial situation.
While there are a number of pros to refinancing a loan, obviously it’s also important to consider the potential downsides as well. Some cons to refinancing a loan might include:
1. Con: There may be fees that need to be paid.
A consumer may need to pay a penalty fee for repaying a loan early. There may also be fees (depending on what state you live in) to re-register a car, for example. When refinancing, the person may also need to pay an application fee to the refinance lender.
2. Con: The borrower may pay more interest in the long term.
If the goal of refinancing a loan is to decrease how high monthly payments are, the loan will likely be extended. This means that the borrower will be paying interest for a longer period. Even if refinancing allows someone to get a reduced interest rate, the cost of paying interest for an extra year or so may mean higher interest costs over time.
3. Con: It’s easy to end up owing more than a home or car is worth.
If someone refinances to tap into home or car equity or to extend the time to pay back the loan, it’s all too easy for them to end up owing more than a car or house is worth. Fluctuations in the market (for homes) or depreciation (for cars) can easily cause a car or house’s worth to decrease. This is often referred to as being “upside-down” on a loan. With home loans, it’s often called an “underwater” mortgage.
How Does Refinancing a Loan Affect Your Credit?
Apart from the general pros and cons, there are also potential repercussions on one’s credit, both good and bad. Some of the different ways refinancing can actually hurt someone’s credit includes:
1. Applying to refinance a loan requires a credit check.
After someone applies for a loan, there will be a hard inquiry on their credit report when the potential lender checks that person’s credit score and history.
2. There are several loan applications.
It’s common for people who are in the process of refinancing to apply for loans with many different lenders to find out which lender will give the best interest rates. Multiple hard inquiries throughout this process can lower a person’s credit score. The way around this is for a consumer to submit all loan applications within the same short period, as many credit scoring models will treat all loan inquiries in the same 45-day period as one inquiry. This will minimize the effect on a person’s credit score.
3. An account will be closed.
The original loan will appear as a closed account on the person’s credit report. This may lower someone’s credit score because a long-standing account is closed. In some cases, credit scoring models will take into account the person’s payment history on the loan. It also shouldn’t take long for the person to improve their credit score if they make on-time payments to the new loan.
Other Ways to Save Money
If the goal of refinancing a car or home is to save money and increase cash flow, it may be helpful to try some other ways to save money without refinancing. Some things people do to save money on a mortgage without refinancing are:
- Recasting a mortgage – When someone recasts a mortgage, they pay a lump sum toward the loan principal. This then resets the monthly payment based on the new balance.
- Consider an Adjustable Rate Mortgage – An Adjustable Rate Mortgage (ARM) is a great approach for someone who doesn’t plan to live in their home for more than five years. With an ARM, the homeowner gets a lower rate during the first five years. After that, the rate will become variable and match the prime rate.
- Consider approaching your living situation differently — for example, renting or owning a multi-family home could help bring in more income streams to pay toward the overall mortgage.
Meanwhile, some methods for saving money as a driver include:
- Becoming a safer driver – People with better driving records pay less in car insurance. This can particularly be a concern for teen drivers with no experience. Fortunately, there are many strategies for better driving and even apps that can help teens become better drivers.
- Taking care of preventive maintenance – Keeping up with the necessary vehicle maintenance can help a car run longer, be more fuel-efficient, and make it safer. Plus, a driver won’t need to spend a ton of money on emergency fixes if they are keeping their car properly maintained.
Further, no matter what type of loan a person has, it’s always a good idea to keep the following in mind:
- Make biweekly payments – There are 52 weeks in a year. If someone makes half payments every two weeks instead of once a month, that equals out to 26 payments, which is 13 full payments in a year. If they only pay once a month, they will only make 12 full payments in a year.
- Make an extra annual payment – Even making one extra payment with a holiday bonus or birthday money can make a significant impact over time.
Ultimately, there are many good reasons to refinance a loan — but it’s not always the best decision for everyone at any time. For anyone considering refinancing, the most important thing to keep in mind is simply considering their personal circumstances, their goals, and whether or not refinancing is good for them in the moment, or perhaps at a later date instead.