This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation.
Have you ever thought about how lenders compare applicants? Imagine you're a lender considering two loan applications. One comes from a young college student who has a part-time job. The other is from a working professional with a salaried job and well-established credit history. Perhaps you decide to approve both applications, but you give the working professional a lower interest rate because it's a less risky loan.
Now consider how your view might change when the college student graduates, finds a full-time job and builds her credit. She is a much lower risk and as such could be eligible for more favorable loan terms -- not just on loans she's applying for now, but she might be able to refinance the debt she took on earlier in life and take advantage of improved circumstances. As a result, she could decrease her interest rate and lower her monthly payment.
Refinancing, which is often done by taking out a new loan to pay off existing debt, can be a simple way to save a lot of money. In some cases, you can submit all the information online, and the entire process will only take a few days. However, refinancing more complex debts, such as a mortgage, can take considerably longer.
While refinancing doesn't always make sense, it's worth considering if you're in one of the following situations.
Your eligibility for a low-interest loan improves. Lenders often consider multiple factors when screening loan applicants. Your credit history, income, outstanding debts and employment could all come into play. Refinancing could make sense if you've improved in one, or even better multiple, of these factors since you first took out a loan.
Interest rates dropped. Some loans' interest rates depend on a benchmark interest rate, such as the London Interbank Offered Rate (LIBOR). When the benchmark rate rises or falls, the interest rate that's offered on new loans could rise or fall as well. Even if your financial profile hasn't improved, if the benchmark has fallen since you first took out a loan, you might consider refinancing to lock in a lower interest rate.
You want to change the terms of your loan. Because you're taking out a new loan to pay off existing debt, you might have the opportunity to change the terms of the loan. For example, you could have a variable-rate student loan whose interest rate rises or falls with a benchmark. You might be able to refinance with a fixed-rate student loan and have certainty that your monthly payments won't change in the future.
If you have a lower interest rate after refinancing and have the same amount, or less, time to repay the loan, you can save money over the lifetime of the loan.
You're having trouble making payments. You might be able to lower your monthly payments by refinancing. Say you have a 30-year mortgage that you've been paying off for five years. If you refinance with another 30-year mortgage, you have an extra five years to pay off approximately the same amount of money. As a result, your monthly payments could be lower, but be sure to take into consideration the fact that you will likely wind up paying more in interest.
You've established equity in your home. If you took out a government-secured mortgage, such as a Federal Housing Administration (FHA) loan, you may need to purchase mortgage insurance. This also applies to most conventional (non-government-secured) mortgages if you put less than 20 percent down. While borrowers pay the insurance premiums, the policies help protect the lenders.
Mortgage insurance could remain with a government-secured mortgage for the lifetime of the loan. However, you may be able to remove it by refinancing with a conventional loan once you've built up or can pay for at least 20 percent equity in your home.
Private mortgage insurance (PMI) generally automatically drops off conventional loans once you establish at least 22 percent equity in your home, based on the home's original value. Or, you can request its removal once you have 20 percent equity based on the original value. If you have 20 percent equity based on the home's current value, you may be able to drop the insurance after refinancing or after a new appraisal, which often costs about $300 to $500.
Your loan has a cosigner. Perhaps you asked someone to cosign your auto loan to improve your chances of getting approved or getting a lower interest rate. If you're eligible for refinancing on your own, you might be able to release your cosigner and take full responsibility for the new loan.
Proceed carefully because applying for refinancing could hurt your credit. Applying for refinancing often results in a hard inquiry, when a potential lender reviews your credit. Generally, a single hard inquiry won't have a large negative impact on credit, but multiple hard inquiries might.
When you're refinancing a mortgage, auto loan or student loans you can still shop around and try to find the best rate without worrying about your credit too much. As long as the hard inquiries happen within a 14- to 45-day period (depending on the credit-scoring model) the credit-scoring model will consider them a single inquiry.
Consider the fees and find your break-even point before refinancing. Depending on the type of debt and the lender, there could be costs associated with refinancing debt. For example, some loans have an origination fee, either a flat fee or a percentage of the loan amount, which could be significant if you're refinancing tens or hundreds of thousands of dollars.
The break-even point is how long it'll take you to recoup the costs associated with refinancing. For example, it could cost you $3,000 to refinance your mortgage, but you'll save $150 each month. You'll break even after 20 months because that's when you'll have saved $3,000 in monthly payments. If you plan on selling the home before the break-even point, it likely doesn't make sense to refinance.
Use the same sort of calculations to weigh the pros and cons of refinancing other types of debts. When it looks like refinancing could be beneficial, shop around to try and find the terms that best fit your needs.
Nathaniel Sillin directs Visa's financial education programs. To follow Practical Money Skills on Twitter: www.twitter.com/PracticalMoney