Important Things to Know Before Refinansiering (Refinancing) a Loan
If you are looking for how to take care of a debt burden that’s weighing you down, refinancing might be a good option. But with the fluctuating economic conditions, you may want to check whether interest rates are low. You could also check whether there is another loan that has a lower rate than what you are currently paying.
You could save some money through refinansiering but be sure that it is the right option for you. In this article, we will explain important things to know before refinansiering. We will also shed more light on the right and wrong time to refinance.
What is Refinancing?
Refinancing is the process of revisiting an existing debt agreement and replacing it with a more favorable one. The new contact could feature a reduction in the interest rate or an extension in the repayment period. Examples of loans that could be refinanced are student loans, mortgages, and car loans. Generally, people refinance when the interest rates are falling so they can save more money on interest.
Types of Refinancing
The types of refinancing available are:
- Rate and term
- Cash in
- Debt consolidation
Rate and Term
This is the basic method of refinancing that involves changing either the repayment interest or the interest rate or even both. Although the amount you owe does not change, the monthly payment reduces.
In this case, you took a loan with collateral and after some time, the value of that asset increased. Now, instead of selling it, you can withdraw its value or equity and then request a higher loan amount. This might attract a high-interest rate, but it gives you access to funds to undertake another project. Also, the collateral still belongs to you.
Assuming you have a lump sum, with cash in refinancing, you can pay off a portion of your debt to reduce your LTV (loan to value) ratio. This will not only reduce the amount you pay back every month but also the interest rate. But before you tow this path, ensure that it won’t affect your living conditions.
Sometimes consumers or businesses take multiple loans with varying interest rates. However, if they find a single loan that has a lower interest rate compared to the other sources, debt consolidation would be a good idea. They can then use the new loan to offset the previous debts, leaving them with their outstanding principal and lower rate payments.
How Does Refinancing Work?
Here’s how refinancing works:
- Read through your current loan contract to be sure you are no longer comfortable with the terms.
- Check whether your lender will penalize you for early payment.
- Look for lenders that offer lower rates than what your current contract offers.
- Compare offers to choose one that suits your present financial situation.
- After choosing a lender, request an application form and fill it out.
- Once the loan is approved, use it to pay off your debt.
These steps are quite different for mortgages. You may want to watch this video to find out how to refinance a mortgage.
When Should You Consider Refinansiering?
Generally, people refinance loans when the interest rate is low. This means they can save some money in the process. There are other reasons to consider refinancing a loan.
Improved Credit Score
People with a good credit score can easily access loans with low interest. So, if your score has improved over time, you can apply for a new loan.
Use the following tips to improve your credit score:
- Pay bills on time.
- Limit the number of times you relocate. Moving frequently gives lenders the impression that you owe rent.
- Quickly report fraudulent activities on your credit report.
- Look for errors on the report, whether it is a typo on your address or a missing letter in your name, then contact your provider for immediate correction.
- Reduce the amount of money you spend on your credit card. If your limit is $2000 and you use up to $1000, it means you have used 50 percent. Keeping it below 30 percent increases your score.
- Avoid applying for new loans too often.
If you lost your job or your income reduces, you may be looking for a loan with a reduced monthly payment. Refinancing the existing debt in exchange for a longer repayment period might make sense. Although it reduces the amount you pay back monthly, it might be too expensive in the future.
The Need to Shorten a Repayment Term
If your income has improved and you can afford to make higher monthly payments, you can take a new loan that has a short repayment plan. Paying your debt within the shortest possible time can save you money because interest rates may go up in the future, causing you to pay more than expected.
Affordable Refinancing Fees
Refinancing involves additional paperwork and extra fees such as application and origination fees. Also, paying your old debt before it expires attracts another fee. But if after considering all these fees and refinancing still seems reasonable, you can go ahead.
When is Refinansiering Not Worth it?
Here are some scenarios when refinansiering isn’t worth considering:
The Repayment Period is Close To its End
If the repayment period of your existing debt is almost over, taking a new loan will only extend it. This implies that you will pay more interest.
Your Credit Score is Still Low
If your credit score has not improved, do not think about applying for another loan. Most lenders consider people with a good credit score. Besides, you can’t get a lower interest rate than what you currently have. So, try improving your score before refinancing.
The Balance of the Existing Loan is Minimal
If the amount left on your old debt is minimal, it isn’t economical to take a new loan. Simply find a means of paying the outstanding to avoid paying more. Refinancing attracts origination fees on the outstanding balance, making it an expensive option.
Higher Interest Rate
The essence of refinancing is to reduce your rates. But if that is not in view, it defeats the aim of the process. However, if you can’t meet up with your monthly payment, you can choose another lender that offers a longer repayment term.
Does Refinansiering Hurt Your Credit Score?
During refinancing lenders check your credit score. Whether it’s for a student loan, mortgage, or car loan, it will affect your score, but you can do something about it.
When lenders assess your score, it is called a hard inquiry. But when multiple lenders do this at different times of the year, it drops your score by 5 points each. And a hard inquiry can reflect in your credit report for two years.
To avoid several hard inquiries, make a list of lenders you want to approach, and then submit your application within the same period. When the lenders pull your report, it would count as one inquiry. You can quickly bounce back by making timely payments.
New Debt Record
FICO score consists of your payment history (35%) and how long you serviced the loan (15%). If you can pay your old loan completely, you will get the whole 50 percent. Lenders like working with borrowers who have a good track record.
When you refinance an old loan, it reduces the length of time you held it and opens a new debt record. This will hurt your credit score for a while, but you can get back on track if you are consistent with payments.
Advantages of Refinansiering
The advantages of refinancing include the following:
- Refinancing when your credit score improves or when you can access a low-interest rate loan helps you to save money.
- It provides stability if you are switching from an adjustable-rate to a fixed one. An adjustable-rate loan comes with fluctuating interest rates. A fixed-rate locks the interest rate based on what is attainable in the market at the time of application.
- It helps to extend your repayment period, especially if you can’t meet up with the monthly payments. Increasing the repayment time reduces the amount you will pay back at the end of the month.
- It enables you to consolidate multiple debts into a single debt. Repaying multiple lenders comes with complexities as you may lose track of who you still owe at the end of the month. Also, the rates for each lender vary. But keeping one loan unifies your interest rate and makes it easy to track payments.
- Refinancing to a short-term loan enables you to pay off your debt faster, thereby, reducing the overall interest.
Disadvantages of Refinansiering
The drawbacks of refinansiering are:
- Refinancing is expensive because lenders expect you to pay some percentage of your outstanding principal. Other fees include closing costs, application, origination, inspection, and appraisal fees. This may ruin your attempt to save money.
- Extending your repayment period amounts to a high-interest rate. This implies that your monthly payments will reduce but the loan will cost more in the long run.
- If you refinance your home, your equity reduces. In some cases, the property is at risk because the lender can seize it if you fail to pay your debt.
- A new inquiry on your credit report could affect your credit score temporarily.
- Some lenders charge a prepayment penalty if you complete your payment before the due date. Ensure you check the contract of your current debt to see whether the lender will penalize you for paying too early.
- Looking for a new loan is time-consuming. You have to scout for lenders and compare offers before applying. If you can’t access funding before your old loan is due, it’s not worth the stress.
Before considering refinansiering, make sure it is what your current financial situation needs. It should give you access to a lower interest rate or extend your repayment term. Remember the advantages and disadvantages we discussed above. Finally, consult your financial advisor to avoid making mistakes.