Refinancing replaces an existing loan with a new loan that pays off the debt of the old loan. The new loan should have better terms or features that improve your finances. The details depend on the type of loan and your lender, but the process typically looks like this:
You have an existing loan you would like to improve in some way.
You find a lender with better loan terms, and you apply for the new loan.
The new loan pays off the existing debt completely.
You make payments on the new loan until you pay it off or refinance it.
The rate-and-term refinance loan is the most popular refinancing loan. It is used to pay off the original mortgage, which is then replaced with a new loan.
Fixed-Rate Refinance Mortgage Loans
A fixed-rate mortgage loan sets a monthly payment during the time of the loan. The monthly principal and interest payment are typically higher than a long-term loan. It also protects from increasing interest rates.
Adjustable-Rate Refinance Mortgage Loans
An adjustable-rate refinance mortgage loan has a fixed interest rate for about 5-7 years. After that period, its rate adjusts based on the conditions of the market. This loan often includes an interest rate cap, limiting how high your interest rate can increase. It gives you some flexibility, especially if you are planning to refinance again in a few years.
Cash-Out Refinance Loans
A cash-out refinance loan works best if you’re in need for some extra cash. It is only used when homes are worth more than what is owed on the existing mortgage. This type of loan replaces your mortgage by paying it off. It then refinances the current mortgage and allows you to keep the difference of the two mortgages in cash.
Save money. A common reason for refinancing is to save money on interest costs. To do so, you typically need to refinance into a loan with an interest rate that is lower than your existing rate. Especially with long-term loans and large dollar amounts, lowering the interest rate can result in significant savings.
Lower payments. Refinancing can lead to lower required monthly payments. The result is easier cash flow management and more money available in the budget for other monthly expenses. When you refinance, you often restart the clock and extend the amount of time you’ll take to repay a loan. Since your balance is most likely smaller than your original loan balance and you have more time to repay, the new monthly payment should decrease.
Shorten the loan term. Instead of extending repayment, you also can refinance into a shorter-term loan. For example, you might have a 30-year home loan, and that loan can be refinanced into a 15-year home loan that typically will come with a lower interest rate. Of course, you can also just make extra payments without refinancing to avoid paying closing costs and keep the flexibility of not being required to make those larger payments.
Consolidate debts. If you have multiple loans, it might make sense to consolidate them into one single loan, especially if you can get a lower interest rate. It’ll be easier to keep track of payments and loans.
Change your loan type. If you have a variable-rate loan, you might prefer to switch to a loan at a fixed rate. A fixed interest rate offers protection if rates are currently low, but expected to rise.
Pay off a loan that’s due. Some loans, particularly balloon loans, have to be repaid on a specific date, but you might not have the funds available for a large lump-sum payment. In those cases, it might make sense to refinance the loan—using a new loan to fund the balloon payment—and take more time to pay off the debt. For example, some business loans are due after just a few years, but they can be refinanced into longer-term debt after the business has established itself and shown a history of making on-time payments.
Disadvantages of Refinance
Transaction costs. Refinancing can be expensive. Especially with loans like home loans, closing costs can add up to thousands of dollars. You want to make sure you'll come out ahead before you pay those costs. Other types of loans, including loans from online lenders, can include processing and origination fees.
Higher interest costs. Refinancing can backfire. When you stretch out loan payments over an extended period, you pay more interest on your debt. You might enjoy lower monthly payments, but that benefit can be offset by the higher lifetime cost of borrowing. Run some numbers to see how much it really costs you to refinance. Do a quick loan amortization to see how your interest costs change with different loans.
Lost benefits. Some loans have useful features that will be eliminated if you refinance. For example, federal student loans are more flexible than private student loans if you fall on hard times. Plus, federal loans might be partially forgiven if your career involves public service. Likewise, keeping a fixed-rate loan might be ideal if interest rates skyrocket—even though you’d temporarily get a lower rate with a variable-rate loan.
What Doesn’t Change
Debt. Your loan balance will not change unless you take on more debt while refinancing. It’s possible to do cash-out refinancing or roll your closing costs into your loan, but that just increases your debt burden.
Collateral. If you used collateral for the loan, that collateral probably will still be required for the new loan.