Last Updated on November 19, 2020
This page provides detailed information on how personal loan refinancing works. Here you will learn what refinancing is, how refinancing works, types of refinancing, the benefits of refinancing, complete personal loan refinancing process for beginners, and all other important personal loan refinancing information that you might need. Keep for updates.
Table of Contents
What Is Refinancing?
Refinancing involves the process of reviewing and replacing the terms of an existing credit agreement, usually with respect to a loan or mortgage.
When a business or individual decides to refinance a credit obligation, they are effectively seeking to make favorable changes to their interest rate, payment schedule, and / or other terms set out in their contract. If approved, the borrower gets a new contract that replaces the original agreement.
Borrowers often choose to refinance when the terms of interest rates change significantly, causing potential savings on debt repayments under the new arrangement.
How Refinancing Works?
Consumers typically seek to refinance certain debts in order to obtain more favorable borrowing terms, often in response to changing economic conditions. The common goals of refinancing are to lower its fixed interest rate to reduce payments over the life of the loan, change the term of the loan, or move from a fixed rate mortgage to an adjustable rate mortgage (ARM) or vice versa.
Borrowers can also refinance because their credit profile has improved, due to changes in their long-term financial plans, or to pay off existing debts by consolidating them into one loan at a low cost.
The most common motivation for refinancing is the interest rate environment. As interest rates are cyclical, many consumers choose to refinance when rates fall. National monetary policy, the economic cycle, and market competition can be key factors that raise or lower interest rates for consumers and businesses.
These factors can influence interest rates across all types of credit products, including both non-revolving loans and revolving credit cards. In a rising-rate environment, debtors with variable-interest-rate products end up paying more in interest; the reverse is true in a falling-rate environment.
In order to refinance, a borrower must approach either their existing lender or a new one with the request and complete a new loan application. Refinancing subsequently involves re-evaluating an individual’s or a business’ credit terms and financial situation. Consumer loans typically considered for refinancing include mortgage loans, car loans, and student loans.
Businesses may also seek to refinance mortgage loans on commercial properties. Many business investors will evaluate their corporate balance sheets for business loans issued by creditors that could benefit from lower market rates or an improved credit profile.
Types of Refinancing
There exist several types of refinancing options. The type of loan that a borrower decides to get depends on the needs of the borrower. Some of these refinancing options include:
1. Rate-and-term refinancing
The most common type of refinancing. Rate-and-term refinancing occurs when the original loan is paid and replaced with a new loan agreement that requires lower interest payments.
2. Cash-out refinancing
Cash-out refinancing are common when the underlying asset used as collateral has increased in value. A transaction involves the withdrawal of value or equity in an asset in exchange for a higher loan amount and often a higher interest rate. In other words, when an asset increases in value on paper, you can access that value through a loan rather than selling it. This option increases the total loan amount but gives the borrower immediate access to funds while retaining ownership of the asset.
3. Cash-in refinancing
A cash-in refinance allows the borrower to pay down some portion of the loan for a lower loan-to-value (LTV) ratio or smaller loan payments.
4. Consolidation refinancing
In some cases, a consolidation loan may be an effective way to refinance. A consolidation refinancing can be used when an investor obtains a single loan at a rate that is lower than their current average interest rate across several credit products. This type of refinancing requires the consumer or business to apply for a new loan at a lower rate and then pay off existing debt with the new loan, leaving their total outstanding principal with substantially lower interest rate payments.
Understanding Personal Loan Refinancing
When you refinance a personal loan, you are using a brand new loan to pay off your existing loan. This strategy can save you money if you qualify for a lower interest rate on your new loan.
There are many different reasons why someone might want to do this, but ideally, you will get a new, better interest rate as part of the process. Refinancing a personal loan can also be a good option for people looking to reduce their monthly payments by extending the loan term.
When Is the Best Time to Refinance Your Personal Loans?
Refinancing your loan almost always makes sense if it saves you money. However, there are certain circumstances where refinancing a loan makes more sense and is more beneficial to the borrower. Consider refinancing your personal loan if you:
- You have a better credit score: One of the best ways to qualify for a lower interest rate on your personal loan is by improving your credit score. If your score has seen a jump since you initially took out your loan, this could be a good reason to refinance.
- You want to switch your rate type: Having a variable APR on a personal loan makes it difficult to plan for your monthly payments. Not only that, you might see an upward trend that ends up costing you more. By refinancing, you can switch from a variable to a fixed rate so you can enjoy consistent payment amounts each month.
- You want to avoid a balloon payment: Some personal loans may come with a balloon payment, requiring you to make a much larger payment than the normal monthly amount at the end of your repayment period. You can refinance ahead of time to avoid this style of personal loan.
- Your income decreased and you need lower monthly payments: If you’ve lost your job or have reduced income, you may be looking to lower your monthly loan payment. In this case, you may want to refinance your current loan for a longer repayment term, which may not save you money in the long run but could help reduce the monthly payment.
Where Is The Best Place to Refinance Personal Loans?
Where is the best place to refinance personal loans? The answer varies based on each borrower’s needs, preferences and credit history. The good news is there are a variety of options out there to consider.
1. Banks
When dealing with banks, you have the opportunity to get preapproved for several personal loans, compare rates and identify the best offer for you. Banks may advertise low or competitive interest rates but often only offer those to borrowers they define as having “excellent” credit.
Still, if you have a solid repayment history, avoid maxing out your credit cards, and can prove your creditworthiness, there’s a strong chance you’ll qualify for a bank personal loan.
Before applying, check your credit score. This will give you an idea of whether or not you’ll qualify for a bank personal loan, as well as how low your interest payments will be.
2. Credit Unions
A credit union is a nonprofit organization that returns profits to its members through higher savings rates as well as lower fees and loan rates.
Membership comes with benefits. Credit unions generally offer lower interest rates than banks do. According to the National Credit Union Administration, the average credit union interest rate on a five-year new-car loan in the third quarter of 2018 was 3.37%, while the average rate for the same loan through a bank was 4.93%.
If you have poor credit, a credit union may be more flexible than a bank. Credit unions build relationships with their members that allow them to offer a more personalized experience.
3. Online Lenders
With online lenders, you can easily shop around and evaluate rates and loan terms from the comfort of your living room. In some cases, you can preview offers from various lenders on one site so you can easily compare loans side by side.
Customer service may vary drastically from company to company. Research the lender’s customer service history before signing on the dotted line. As with banks and credit unions, you should check out reviews on sites such as Yelp, and be sure to check with the Better Business Bureau and Consumer Financial Protection Bureau to see if any complaints have been lodged against the company.
RECOMMENDED: A Complete Beginners Guide to Finding the Best Personal Loans
Personal Loan Refinancing Process: How to Refinance Your Personal Loans
The personal loan refinancing process varies depending on the lender. However, it is largely similar to the standard loan application process. Follow these steps to refinance your personal loan:
1. Know How Much Money You Need
When you refinance a loan, you’re essentially paying off the existing loan with a new one that has different terms. So, before you shop for quotes, determine the exact amount of money required to pay off your current loan. You can get that information by logging into your account or directly calling your lender. Also ask if there are any prepayment penalties that might outweigh the benefits of refinancing.
2. Check Your Credit Score and Report
Before you consider refinancing your loan, you’ll need to know whether you qualify for a lower rate than what you’re currently paying. If the new interest rate isn’t significantly lower, it may not be worth it to refinance.
“Most lenders will quote their best rate, but if you don’t have an excellent A-plus credit, which may not be the rate you qualify for,” says Marlowe. “To get your credit score, check to see if your credit card issuer or financial institution provides this for free to their customers.”
You can also request a free credit report annually from each of the three credit bureaus — Equifax, Experian and TransUnion.
As you’re shopping around for a new loan, determine whether lenders do a soft pull or hard pull of your credit score when giving you a quote. A hard credit score will negatively affect your score, at least in the short term.
“Be sure to not allow lending institutions to pull your credit score until you are ready to decide on a loan and a lender,” says Jeff Wood, CPA and partner at Lift Financial. If a lender offers prequalification, you’ll be able to check your rate without formally applying, and the lender will do only a soft credit check.
3. Shop for Rates and Terms at Banks, Credit Union and Online Lenders
Research is key in refinancing personal loans; before refinancing, compare rates and terms from multiple lenders. A new loan with a lower interest rate isn’t necessarily better if you’re paying more for it overall in fees or by extending it unnecessarily.
“Refinancing a loan may cost additional fees and will change the terms of the loan,” says Wood. “Your current loan may have a prepayment penalty in order to replace it. All of these factors must be considered to determine if a refinance makes sense, both personally and financially.”
If you’re not looking for lower monthly payments, it may also be unwise to extend the maturity of your new loan past the maturity of the current loan. Even if you get a lower interest rate, you could end up paying more in interest over a longer time frame. To compare the overall costs of your loans, try using a personal loan calculator.
4. Speak With Your Current Lender
Don’t overlook your current lender during the research process. It may be willing to work with you and offer you a better deal than your existing loan.
“You already have an established relationship with that company,” says Awumey. “Your lender will assess your needs and determine your eligibility for a new loan. Many lenders will let you see if you are pre-qualified for a loan without making a credit inquiry.”
5. Apply For the Loan
Once you’ve chosen the lender whose offer you like best, submit your application and provide any required proof – this could include your social security number, payment receipts, bank statements or tax documents. Also, remember to read the fine print of the loan before accepting it, noting your payment schedule and any fees, including prepayment penalties.
If you’re satisfied with the terms of the loan, you can accept it and typically receive funds within a few days. You’ll use these funds to pay off your current loan, then enter the repayment period of your new loan.
Benefits of Refinancing Your Personal Loans
Refinancing a personal loan offers several potential advantages, including:
- Better interest rate: If rates have dropped or you have taken steps to improve your credit score, you could be able to save money on interest.
- Faster loan payoff: If you’re comfortable making higher monthly payments and you want to get out of debt faster, you can refinance a personal loan to a shorter term. This has the added benefit of reducing the amount of interest you’ll pay overall.
- Extended repayment periods: Extending your loan repayment can help your payments feel more manageable if you’re having difficulty making them on time, since lengthening the terms will reduce your monthly bill.
- Payment stability: Refinancing can provide payment stability if you’re switching from a variable rate to a fixed rate.
If you’re looking to refinance a personal loan, it’s important to do your research: will you get a lower interest rate? A lower monthly payment? Better terms? Once you’ve compared the pros and cons and shopped with several lenders, you can determine if refinancing makes sense.
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