Financially speaking, when you refinance you trade in one loan for another, hopefully better, loan. When you refinance a loan, you are usually trying to achieve at least one of three possible goals. First, to save money by getting a loan with a lower interest rate. Second, to lower monthly payments to make them more affordable. The third possible goal is, if the loan is for property, to access the equity.
Since you are trading one loan for another, a refinance often involves going through the entire loan application process again. Going through the loan process means there will be a hard check on your credit. To get the best possible rates for your new loan, no matter what the loan is for, be sure your credit score is in tip top shape before you apply. You can check your credit score for free on Credit Sesame. Credit Sesame also provides a free credit report card and guidance for making improvements.
Refinancing student loans vs. auto loans vs. home loans
The goals and potential benefits of refinancing vary depending on the type of loan you want to refinance. Since student loans, auto loans, and home loans are all used for specific purposes, it makes sense that you may have different specific goals for refinancing them.
Refinancing student loans
Whether or not refinancing student loans will be financially beneficial depends in part on whether the loans are federal student loans or private student loans.
Federal student loans come with lots of benefits including income-driven repayment plans, extended repayment, and graduated repayment options. They also have more flexible default rules and allow you to defer payments or apply for a forbearance, depending on your situation. As there are no options to refinance federal loans using another federal loan, you would have to refinance using a private loan, giving up all of the benefits federal loans offer.
Proceed with extreme caution if you’re considering refinancing federal student loans.
If you have private student loans, you would simply trade one private loan for another. The only way refinancing a private student loan can hurt you is if the new loan doesn’t come with better terms. You’ll probably lose a few points as a result of the hard inquiry into your credit, all for naught if you don’t end up following through with the refinance.
If you are offered a better interest rate or lower monthly payments or both, you could save hundreds or thousands of dollars over the life of the loan — a great trade for the mild and short-term credit score damage.
For example, you have a $15,000 loan at 7.5% interest rate and a monthly payment of $178. If you refinance to a 6.5% interest rate and a monthly payment of $150, you would save $865 over the life of the loan, while also achieving some relief from the monthly financial burden.
Refinancing auto loans
Generally when refinancing an auto loan you are trying to save money by lowering the interest rate, or shortening or extending the term. The difficulty with refinancing an auto loan is that an automobile, unlike student loans and most residential properties, is a depreciating asset. The value drops as soon as you drive it off the lot. If you currently owe more on your loan than your car is worth, you will have difficulty finding a lender willing to refinance your current auto loan.
If on the other hand, you owe less than the car is worth, you may be able to find a better deal, especially if your payment history is strong on the existing loan. Just find out the current interest rates on auto loans. Auto loans usually have low interest rates, often around 4-5% or lower. Auto loans also usually have shorter loan terms — 5-7 years at most. Before you refinance, make sure you understand your current interest rate and loan term. While you can certainly save money by refinancing an auto loan, you may not save as much as you think.
For example, let’s say you have a balance of $8,000 on your car worth $10,000. Your interest rate is 4.5% and your monthly payment is $250. You have three years left on your loan term. If you refinance at a rate of 3.5%, you will save $127.60 in interest over the course of three years. If you refinance at the lower rate and lower your payment to $150 by extending your loan term one year, you will pay more interest over the life of the loan than you would have on the original auto loan. If a lower monthly payment is what you need, you may feel okay with paying more overall.
If you do decide to refinance your auto loan, make sure the new loan is going to accomplish the goal you are trying to achieve, be it saving money or lowering your monthly payment or both.
Refinancing a home loan
When you refinance a home, you may decide to do so for several reasons. Like other refinancing goals, you may want to save on interest or to lower your monthly payments. However, with a home loan, another reason you may decide to refinance is to access some of the equity in your home (cash out part of your investment in your home to pay for other things).
Equity is the portion of the value of your home that you own. For example, if you made a 20% down payment when you bought your house and financed 80%, then you have 20% equity in your home. If the home value increases, you have even more equity. With each payment, your equity goes up a little bit (more and more as the loan ages). Unlike cars that are depreciating assets, a home’s value is likely to increase over the life of your loan.
You can refinance to cash out some of the equity to pay for things like education, a car, higher interest debt or remodeling your home. For example, let’s say you have 50% equity in your home and you still owe half the value on your mortgage. You could refinance (replace your old mortgage with a new one) for 75% of the value of your home and cash out 25% (the difference between what you owned and what you owed).
Since a cash-out refinance is based on the home’s value, in addition to credit and income checks, you will have to have the home appraised. The lender chooses the appraiser. The process to refinance to access equity can be a bit more complicated than refinancing for a new interest rate.
Because interest rates for mortgages are lower than interest rates for nearly any other type of loan, you might save money by borrowing against your home instead of accessing other, more expensive credit products (like an auto loan or a personal loan). But as in the auto loan example above, adding time to your loan can increase costs overall. If you borrow against your home to consolidate credit card debt but take 30 years to repay the loan, you might pay greater interest charges overall.
Finding the right refinance loan for you
Refinancing is to solve a problem (you want a lower interest rate or you’re unhappy with the lender or you need cash, etc.). Whatever the motivating factor is, be sure you choose a new loan that solves the problem.
Take the time to compare lenders and what they offer. Do a soft application whenever possible. Some lenders can take information from you and give you an idea of what terms you’ll qualify for before you actually apply and trigger the hard inquiry on your credit.
While a hard check usually has a low impact on your credit score overall, multiple hard checks add up to greater damage, and some lenders won’t consider your application if you’ve got too many in the past six or 12 months.
You do have a window to rate shop for certain kinds of loans. Mortgage, student and auto lenders are classified as such by the credit scoring agencies. When you apply with multiple lenders in the same category, the inquiries won’t count against your score at all for 30 days from the first inquiry. Then, all of the inquiries made by that category of lender during the rate-shopping window count as just one inquiry against your score. The rate shopping window varies from 14 to 45 days, depending on the credit scoring model, so to be safe, shop within a 2-week time frame. You can also ask the lender to confirm that their inquiry will show up as being in the right category.
Why you might not want the loan that saves you the most
The right refinance loan for you may not always be the one that could save you the most money. It’s the loan that provides you the most peace of mind. This means you’ll have to decide things like whether you want to give up the benefits that come with federal student loans, whether you are comfortable with variable interest rates or if you’d rather have a fixed interest rate, how long you want your loan term to be and what monthly payment you can afford.
Remember, you are refinancing a loan for a term that typically covers years rather than months. Think about what your finances might look like in the future before you decide on the loan that will work best for your current situation.
Now that you know what refinancing is and the pros and cons of refinancing student loans, auto loans, and home loans you can decide if refinancing will be right for you and your financial situation. Keep your rate shopping period to two weeks, and do your research before you start applying so that you’ll know the right loan when you find it.