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How and When To Refinance a Personal Loan
When you refinance a personal loan, you apply for your new loan and use those new funds to pay off your old loan. You can get your loan from a new lender or the same one. You'll start to make your payments on the new loan with your new terms and rates. There are many reasons to do this, but saving money is why you refinance.
When Is the Best Time to Refinance a Personal Loan?
Saving money is the primary goal of refinancing a personal loan. Here are the reasons why it makes sense:
Your Credit Score Improves
To get a lower interest, you need to improve your credit score. If you check your score and it has increased since you received your loan, this is an excellent reason to begin the refinancing process.
Your Wage Decreased
If your income has decreased or you lost your job, you'll want to lower your monthly payment to an affordable amount. You can refinance your loan for a longer term. It may not save you money in the long term, but it avoids defaulting on your loan.
Your Loan Rate Type
Not all Annual Percentage Rates (APRs) are equal. A personal loan with a variable APR makes it challenging to budget monthly payments. It's also possible that your rate is trending upward and costing you more money. You refinance to a fixed rate to keep your monthly payments predictable.
Your Loan Paid Off Faster
Sometimes, you can afford a larger payment. You have the option to refinance into a shorter loan term. You'll save a large amount of money in interest over time.
Your Balloon Payment
Suppose your loan includes a balloon payment, which requires you to make a significantly larger payment than your regular monthly amount at the end of your loan term. Refinancing ahead of time can prevent you from paying that balloon payment.
You Can Afford Fees
When you refinance your loan, you can incur specific fees, such as application fees or origination fees. Your current lender may charge you a prepayment fee if you pay the loan off early. Before you refinance, your new loan must be less expensive after factoring in costs.
When Is It a Bad Idea to Refinance a Personal Loan?
You should also consider these circumstances in which it may not make sense to refinance your current loan:
Current Loan Has A Low Balance
If you've paid off a majority of your loan, origination fees on your new loan could offset the benefit of refinancing if your current loan has less than 12 to 18 months of payments.
Interest Rates Are Higher
Interest rates rise and fall. If they have increased since you were approved for your current loans, it might be impossible to get a lower rate even if your credit score has improved.
Planning For A Mortgage Soon
If you're getting a large loan, such as a mortgage, in the next 6 to 12 months, it's ill-advised to apply for any credit. Your credit score drops after the approval of new credit. Avoid submitting any new application to give you the best scores when applying for a mortgage.
How to Refinance a Personal Loan
Start with these steps if you feel refinancing makes financial sense:
Determine The Amount Of Money You Need
Before researching different lenders, it's crucial to determine the exact amount you'll need to pay off your existing loan free and clear. Be sure to speak with your current lender to guarantee that you will not be charged prepayment fees that cost more than the money you would save from refinancing.
Know Your Credit Score
Check your credit report and score before you consider refinancing. If you are in a better position, you'll need to qualify for a lower rate than your current loan. Refinancing probably won't be worth it if your interest rate is not significantly lower.
To get your credit score for free, you can start with your financial institution or credit card provider. They could provide you with the information. Also, each credit bureau will give you an annual free credit report.
As you shop around for your new loan, check to see if potential lenders perform a hard or soft credit check when giving you a quote. The hard credit check will negatively affect your score in the short term.
Talk To Your Current Lender
Your current lender is an excellent place to start during your research process. If you have a positive relationship with them, they may be willing to offer a special deal than your current loan to keep your business. They could also get you prequalified without a credit inquiry.
Shop For Rates
Research and compare terms and rates from various lenders before you refinance. Shopping around online is essential because rates and terms vary between lenders. If you end up paying more for your new loan with additional fees or extending the length of payments, the lower interest rate will not save you money.
Even if you're looking for lower monthly payments, it will cost you more over time to extend the maturity of your new loan past your old one.
Apply For Your New Loan
When you've found a lender that suits your needs, you submit your application and provide any required documents. Standard information you'll need will be paystubs, W2s, social security numbers, and bank statements.
Keep in mind that your requirements for getting quotes from lenders are not the same as the formal application. To officially undergo the loan underwriting process and receive your funds, you must submit a formal refinancing application.
Make Your Payments
Once you receive your new funds, you or your lender will pay off your existing loan. If you can pay off the old loan yourself, ensure that you pay it off as soon as possible to avoid fees, interest, or double loan payments. Receiving your loan funds also begins your new loan repayment period. Your new monthly payments will start with your payment amount, interest rate, and new timeline. Keep your account in good standing and make your payments on time.
Will Refinancing Hurt My Credit?
You may see a dip in your credit score because you're paying off a loan and getting a new one. Here are some reasons this could happen:
Adding New Accounts
Suppose you've recently applied or taken out other credit lines or loans. Your credit scores will lower. The credit bureaus consider several new accounts a more significant risk.
Closing An Old Account
After refinancing, your original loan will be closed. Some credit scoring systems consider paying off your debt with a loan as unfavorable in ways that car loans or mortgages are not. The average age of your accounts is also considered on your credit reports. Some credit scoring models will not consider your old loan on that average. FICO® credit scores use 15% of their score for the length of your credit history.
Hard Credit Checks
When applying for a refinance loan, your lender will perform a hard inquiry to check your credit scores and history. Your credit scores could see a slight drop from this inquiry. You can minimize the effect on your credit scores if you submit your applications within two weeks. Many credit-scoring models, not all, consider multiple inquiries in that 14-day window as only one inquiry.
Refinancing a loan can affect your credit over the short term, but there are upsides. If your new loan makes it easier to pay, make on-time payments, and pay off early, these actions will positively affect your credit. Since the amount you owe on your accounts determines 30% and your payment history accounts for 35% of your FICO® scores.
Pros and Cons of Refinancing a Personal Loan
There are positives and negatives when refinancing your loan. It's up to you to decide if one outweighs the other. Here's what you need to know.
Advantages Of Refinancing A Personal Loan
Your goals will determine the advantages of refinancing, but they generally include reducing the loan cost and getting a lower interest rate. Consider these advantages and discover if refinancing is right for you:
- Payoff your loan faster: If you can afford to make higher monthly payments to get out of debt more quickly, you can refinance for a shorter loan term. It also reduces the amount of interest you pay over time.
- Predictable payments: If you switch from a variable rate loan to a fixed rate, you'll know the payment amounts and the term length to help you budget.
- More extended repayment period: If you have difficulty paying your loan on time, refinancing with a lengthier term will reduce your monthly payments and help your finances more manageable.
- Lower interest rate: If you've improved your credit score or interest rates have dropped, you could save money.
Disadvantages Of Refinancing A Personal Loan
Not everyone needs to refinance their loan. Before you commit to refinancing, you need to consider these drawbacks:
- Higher interest costs: Will extending your loan increase interest costs over time? If you are struggling financially, it makes sense to lower your payments. But, keep in mind that reducing your monthly payment and extending your loan term will cost you more money.
- Prepayment penalties and extra fees: Always read the fine print when looking to refinance. Check the terms of your current loan and determine if you will be penalized for paying it off early. Also, read the terms of your potential new loan to see if processing or the charges wipe out any money you could save with refinancing.
- Time to research and get funds: A significant amount of time needs to research lenders, compare interest rates, and qualify for a loan. Refinancing may not be worth the hassle if your current loan is close to being paid off.
Is Refinancing Right for You?
If you're debating refinancing your loan, you'll need to compare the pros and cons. Determine if refinancing will save you money, decrease monthly payments, or both. If you benefit from refinancing, check your credit scores, research if there are any fees, and check interest rate options from different lenders and how this decision will affect your credit score.
Joseph Priebe takes pride in assisting audiences with his articles to help them make sound financial decisions.
With over ten years of experience writing financial content his goal at CASH 1 has always been creating engaging and easy-to-digest information for anyone searching for immediate or long-term monetary solutions.
When Joseph is not writing about personal finance, you can find him photographing the Southwest United States with his 4x5 Graflex Crown Graphic camera. He is based in Phoenix, Arizona.