Refinancing may offer several benefits for you. However, before you head out and apply for refinancing, there are things that you should learn regarding its benefits and risk.
What is Refinancing?
Refinancing is a key strategy that can help your finances in the long-run. When you refinance, you essentially take out a new loan to pay off the debt owed on an old loan. While on the surface it may sound like you’re merely replacing one loan for another, the new loan should have financial benefits such as better terms, interest rates, or features that will benefit you more than your old loan.
Numerous types of loans have refinancing options such as home mortgages, auto loans, personal loans, and student loans.
What are the Benefits and Risks When You Refinance a Loan?
Stated by a credit repair company, when making a financial decision as important as refinancing, it’s vital to understand both the benefits and potential risks you face in the process. Never enter a refinancing situation when you are unaware of the precise terms, conditions, benefits, and adverse effects that it may have on your financial record.
Lower Your Interest Rate
Many people choose to refinance their loans because a better interest rate is available. This is a good reason since lower interest rates mean savings in the long run. The less you must pay in interest, the more you’ll save during the life of your loan. This is especially true with significantly large loans such as school, home, or auto.
Reduce Monthly Payments
If you found a loan with a lower interest rate, you can probably afford to make smaller payments than on your original loan. If you need lower monthly payments, this could be an excellent direction to take. Be sure that your extended payment plan doesn’t end up making you pay more in the end due to an increased duration of your payment plan.
Change Repayment Term
Do you want to change your repayment term to extend or shorten the length of your loan? Refinancing can help you do that. Most people want to extend the period of their loan payment and find that a refinanced loan with a lower interest rate is helpful to extend the duration of their loan. You can also choose to refinance a long-term loan into a shorter-term option.
Change Loan Type
Refinancing gives you the option to change the type of loan you take out. Many who have acquired a variable-rate loan change to a fixed-rate loan. Variable-rate loans cause your monthly payment to go up and down as interest rates change. A fixed-rate loan, on the other hand, applies a fixed monthly payment to the entire term of your loan. If you need the stability that a fixed-rate loan provides, but you have a variable-rate loan, then refinancing could be a good option.
If you have multiple loans, refinancing can help you condense them all into one single loan. Not only will it be easier to keep track of your total debt, but it could help you save money in the long-run if you find an option with a lower interest rate.
Risks When You Refinance a Loan
As with anything in life, there are positives and negatives with refinancing. Here are three downsides that you should consider before deciding to refinance.
Transaction Costs are Expensive
When you refinance, you’ll have to pay closing costs just like you did when you first drew the loan. If you’re refinancing a significant loan such as home or auto, your closing costs could be in the thousands. You’ll need to determine whether the new terms outweigh the closing costs you’ll pay to secure the loan.
Higher Long-Term Interest Cost
Refinancing is often used to extend a loan period. Though your monthly payments will likely be lowered, if you stretch your loan out significantly, you could end up paying substantially more in interest.
Risk Losing Value and Benefits
Understand what you will be losing if you refinance. Does your present loan offer benefits that you can’t live without? Even though a refinanced loan may provide some savings, you might be better off keeping your current loan in order to keep your benefits.
What Happens to Your Credit Score When You Refinance a Loan?
As beneficial as refinancing a loan may be, it will impact your credit score. Keep these issues in mind when deciding whether refinancing is worth it.
Credit Inquiries Affect Your Score
When you apply for a refinance loan, the lending company will inquire into your credit score and credit history. This is known as a “hard inquiry.” Though temporary, this type of inquiry will negatively impact your credit score.
Multiple Loan Applications Can Negatively Impact Your Credit Score
Your application itself isn’t what will hurt your credit score. With each application, however, a hard inquiry will be made by the lending company. When several hard inquiries are made over a short amount of time, your credit score will be negatively impacted. The good thing is that the impact is only short-lived. Be sure to submit your loan applications over the same time period, so drawn-out loan applications won’t continually impact your score.
Closing an Account May Lower Your Credit Score
When you refinance, your old loan account will be closed. You’ll then start over with a new loan, a new open date, and a blank payment history. Because of this, your credit score might get lowered. The good news is that, as long as your closed account was in good standing, the negative impact on your score is less than it might be otherwise.
As beneficial as refinancing can be, applying for a refinance loan will almost always lower your credit score. If you do refinance, focus on getting your credit score back to normal by making payments on time, giving your score time to improve, and paying your credit cards off in full each month.