Breaking Down Loan Refinancing
If you're researching ways to pay off debt sooner or get your monthly payments under control, you may have seen information on refinancing a personal loan or installment loan. Refinancing any loan is a big decision, but it could be one that helps you achieve your financial goals sooner rather than later. Before you decide if refinancing is right for you, you'll want to know the ins and outs of taking this big financial step.
How does refinancing a loan work?
First, let's dive into the basics of what is refinancing and what does it mean for you? Refinancing is when you take an existing loan and transfer it to a new loan, with new payment terms. These payment terms typically include a different interest rate and a revised repayment schedule. Refinancing could lower or raise your monthly payment, depending on the interest rate and number of months you have to pay.
Refinancing is available for a variety of loan types — mortgages, auto loans, student loans, and installment loans are a few examples. It's essentially a new contract for your debt repayment. You don't have to work with the same lender as your original loan either, which means you may have numerous options for choosing a lender.
Pros and cons of refinancing a personal loan
Refinancing a loan, particularly an installment loan, comes with certain benefits and potential risks. Consider the following pros and cons as you research your refinance options.
Pros of loan refinance
- A lower interest rate. Usually when someone chooses to refinance it's to lower the interest rate. A lower interest rate payment means more money towards the balance and less towards interest to the lender.
- Reduce the number of monthly payments. If you choose to refinance into a different repayment term, it could lower the number of monthly payments you have to make. This could help you achieve your financial goals and reduce your debt sooner.
- Increased financial responsibility. Refinancing could help you with lowering the monthly payment, which could, in turn, help you make payments on time. Making on-time monthly payments may have a positive impact on your credit score.
- Convenient. Refinancing may offer the opportunity to roll multiple loan payments into one. Not only could this reduce interest payments, it saves you time each month by only having to make one payment.
Cons of loan refinance
- Added costs and fees. Lenders may tack on fees in addition to interest. This might include application, processing, or loan origination fees. Be sure there is no prepayment penalty for paying off your loan early, which lenders may charge.
- There may not be any savings. Once you add in the lender fees, new interest rate, and new number of monthly payments, you may realize there are no overall savings. It's possible a refinance could actually cost you more, which is why it's critical to calculate it before proceeding.
- Impacts on your credit score. Taking out any new loan will impact your credit score. There are credit score impacts associated with lenders viewing your credit report - referred to as a hard credit pull or hard credit check. This could possibly reduce your credit score by a few points. If your credit profile already needs improvement or you will be applying for other loans (such as a mortgage) in the near future, it may not be wise to add this extra activity.
Steps for refinancing a personal loan
If you decide to move forward with refinancing, the steps to refinance an installment loan are fairly straightforward.
- Shop around. Lending is a competitive business, so use it to your advantage and shop multiple lenders. Compare interest rates, fees, and payment terms. You can do this by comparing lenders one by one, or by using an online comparison tool.
- Check your credit score. Before you begin any application process, check your own credit score. You're entitled to three free annual credit reports each year. Reviewing your credit score beforehand will help you avoid surprises when a lender runs a credit check.
- Use a prequalification tool. It's possible to run a lending scenario with a prequalification tool. Many lenders offer this on their website and will let you see if you qualify and the potential interest rate you might get. Prequalifying doesn't have the same impact on your credit score as submitting an application, and it helps you run more realistic calculations to decide if refinancing is worth it.
- Fill out the application. Once you've crunched the numbers and selected a lender, fill out the application per their instructions. Keep in mind that submitting an application will impact your credit score. You should limit the number of lenders you submit applications to if at all possible.
Is refinancing your personal loan worth it?
What makes refinancing tricky is knowing if you should do it or if it's the right time. While everyone's finances are unique, there are a few benchmarks you can use to decide if refinancing is worth it for you. Before jumping into an installment loan refinance, ask yourself these questions:
- What is the reason for the refinance? Is your motivation to lower your payments, pay off your debt sooner, pay less in interest over time, or are you motivated by something else? Understanding why you feel you need to make a change to a loan is the first step, since it helps you answer the next few critical questions.
- What do lower payments mean for my budget? Does the refinancing lower your payments? Sure, your payments may be lower, but it could also stretch out your payments for a longer amount of time and you could be paying more in interest over time. Evaluate how you will use the payment difference. If the smaller payment can help you achieve another financial goal, such as paying off other high-interest debt sooner or establishing an emergency fund, then refinancing may be worth it.
- How does the new interest rate impact payments? Refinancing means you'll lock in a new interest rate. Locking in a lower one almost always makes the most financial sense, given that it allows you to put more money towards your balance and less towards interest. Simply run a quick calculation to make sure your new lower interest rate will be worth it, and don't forget to add in any costs and fees charged by the lender too.
- What is the impact on my credit score? Anytime you open a new credit account or refinance, it will impact your credit score. Your monthly payments are reported to the three credit bureaus: Experian, Equifax, and TransUnion. Paying your monthly payments on time is one of the best actions you can take to proactively and positively impact your credit score. If refinancing helps you make your payments on time each month, there could be additional benefits for your credit.
The bottom line for refinancing personal loans
Refinancing an installment loan may make sense for your personal finances. It could lower your monthly payment or reduce the amount of interest you pay over time. But it comes with other considerations too, such as impacting your credit score, paying additional fees, and changing your payment terms. By researching your installment loan refinance options and comparing multiple lenders, you should be able to confidently answer whether or not refinancing is right for your finances.