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Thinking about refinancing? When interest rates are low, refinancing your loans can help you lower your monthly payments, save money over the life of the loan and even reset your finances.
But before you start submitting applications, first think about how refinancing would (or wouldn't) help you meet your financial goals. Refinancing can help you save money when interest rates drop, but pulling this off also depends on your credit status, overall financial health and other factors.
How Does Refinancing Work?
When you refinance, you replace your current loan with a new one. Depending on interest rates, your financial criteria and what you hope to accomplish, refinancing can help you:
- Lower your monthly payments.
- Reduce the amount of interest you pay over the life of a loan.
- Pay your loan off faster.
- Use your equity to pull out cash.
If you think you can secure lower interest rates, any time could be a good time to consider refinancing your mortgage, auto loan or even your student loans. But first think about your current credit and financial picture. Has your credit improved since you got your original loan? Are your income and savings holding strong? Or, if you're facing some financial challenges, will your financial standing still allow you to secure favorable rates and terms on a new loan?
Here's how some of these factors can play out when you're looking to refinance.
When Can a Mortgage Refinance Save You Money?
Because your mortgage is a large loan with a long payment term, your potential savings are significant. There is no single rule on when it's the right time to refinance your mortgage. On the other hand, if you've refinanced in the past few years and took cash out to pay off debt, modified your loan payments, took out an FHA loan or got a loan with payback restrictions, you may be limited on when you can refinance again. In these cases, check your loan contract for details.
To take advantage of low interest rates, you'll need to qualify for them. Check your credit score and credit report and take steps to improve your credit if necessary. Higher credit scores tend to result in lower rates. Even if your credit isn't stellar, you may still benefit from a refinance if your credit has improved since you got your loan.
How much difference can refinancing make? Suppose you bought a $400,000 home in late 2018. You put 20% down and took out a $320,000, 30-year mortgage at a fixed rate of 4.87%. Your monthly payment is $1,692.
If you refinance now at 3.125%, here are a few ways a new loan might affect you:
- Save on interest over the life of the loan: Your total interest would drop from $289,000 to $173,000 for a savings of $116,000.
- Reduce your monthly payment: You would lower your monthly payment from $1,692 to $1,370, saving you $322 monthly.
- Help you cash out your equity: Early mortgage payments are mostly interest, so if your mortgage is just a few years old, you likely would not have much equity to tap. But if you've had your loan for longer—or your home value has increased—you might be able to pull out some of that equity with a cash-out refinance. This type of refi pays off your existing loan balance but starts you on a new, larger loan. You get the difference between the two loans in cash that you can use to pay off high-interest debt, remodel or simply have extra cash on hand.
- Shorten the life of the loan: If you refinanced your loan over 15 years instead of 30, a lower interest rate of 2.5% could save you nearly $110,000 over the life of the loan and help you live mortgage-free in half the time. On the downside, your monthly payment would jump to $2,131.
Each of these scenarios makes refinancing seem enticing. But there are potential pitfalls to avoid:
Paying too much in points and fees: The money you pay in upfront interest and fees should not outweigh the money you'll save in lower payments or less interest. Be especially mindful if you're planning to move in the next few years.
Inadvertently increasing your debt or lengthening your loan term: When you take cash out or fold fees into your loan balance, you increase the amount you owe. Similarly, if you refinance your 30-year mortgage after five years to another 30-year mortgage, you delay your payoff date. You may be fine with these adjustments, but be aware.
Eroding your equity: Pulling equity out in a refinance reduces your stake in your own home. Also, if housing prices decline in an economic downturn, you could find yourself with very little equity or even "underwater" with negative equity. Proceed with caution.
Getting unappealing terms on your new loan: Do the same due diligence you did on your original loan when you refinance. If you don't want prepayment penalties, for example, make sure they're not included in your loan.
When to Consider an Auto Loan Refinance
Refinancing an auto loan can also help you reduce the amount of interest you pay and possibly also lower your monthly payments. The stakes are lower in an auto refinance, though, since the loans are smaller, the terms are shorter, and origination fees and closing costs are often low to nonexistent.
If you're thinking about refinancing your auto loan, consider the following:
- Can you beat your original interest rate? If your credit score has improved or rates are lower now, you may see savings in both interest paid and monthly payments.
- Has your car held its value? Excess mileage, accident damage—anything that might reduce your car's value—could make it difficult to get a new loan.
- Is your loan nearly paid off? If you're nearing the end of your loan, it may not be worth refinancing.
- Would you consider a longer loan term to get a lower monthly payment? Shaving a point off your interest rate might not save you much, but adding six months or a year to your term could reduce your monthly payment noticeably.
Using an auto finance calculator can give you a quick estimate of savings. On a five-year, $35,000 loan at 8.5% with four years left to pay, refinancing the remaining balance over four years at 3.125% saves you $63 a month and just over $3,000 in interest. If you can't reduce your interest rate but need a lower monthly payment, you can finance the balance over five years to cut your monthly payment by $120, although doing so will increase the total interest paid to almost $1,400 and prolong your financial obligation.
RateGenius, an Experian partner, can help you better understand your auto loan refinance options.
Can Refinancing Your Student Loans Save You Money?
The process of refinancing student loan debt is a bit more complicated than it is with standard home or auto loans because many outstanding student loans are issued by the government. These government loans come with benefits and protections, including income-driven repayment options and payment deferrals.
If you carry student debt, you may be able to refinance your government loans through a private lender, such as a bank or credit union. You'll have to meet standard lending criteria and credit scoring requirements, but you could lower your interest rate and payments.
High earners who expect to pay their loans off without an interruption in income may indeed benefit from private refinancing. But shifting your government student loans to a private lender will cause you to lose benefits like income-driven repayment plans, payment postponement options and other federal loan accommodations.
How Does Refinancing Affect Your Credit?
Whether you're refinancing your home, vehicle or student debt, refinancing a loan has the potential to lower your credit score—at least temporarily. In most cases, this dip should be minor and resolve quickly. Here are a few of the factors that may impact your credit score during a refinance:
- Hard inquiries on your credit: When lenders process your loan application, they do what's called a hard inquiry. These can lower your score by a handful of points, but the score impact will drop off completely after a year.
- Missed payments on your old loan: If a payment is due on your old loan while your refi is processing, pay it. Otherwise, you may end up with a late payment on your credit report.
- Closed accounts and new loans: Closing a longstanding loan account could have a minor impact on your credit score. As long as the account is closed in good standing and you make timely payments on your new loan, your credit should recover.
Overall, refinancing is a key motivator for maintaining your good credit. The ability to lower your interest costs and monthly payments through refinancing can be an important tool for optimizing your long-term financial health.