“Refinancing your mortgage usually makes sense if you can lower your interest rate by at least two points. But the most important question to ask yourself is, how long will it take you to break even?”
— Barbara Corcoran
The word ‘Refinance’ is divided into two parts, Re and Finance, literally meaning financing again. The Cambridge dictionary defines it as ‘the action of replacing a loan with a new one.’ A refinance takes place when a debtor revises the interest rate, payment schedule, and terms of a previous loan or credit agreement. Debtors often choose to refinance a loan agreement when the interest rate has substantially changed, causing grounds for potential savings and debt payments.
Also, in cases where people are paying two separate loans, they can both be clubbed under a single loan via refinancing it; thus, giving the consumer some respite on paying two EMIs. The general idea behind refinancing a mortgage is starting a fresh cycle of your finance, and specifically debt management.
What is refinancing?
Refinancing simply means to pay off an existing loan with money from a new loan, typically of a similar size, using the same collateral. In order to decide whether it is worthwhile, the savings in interest must be weighed against the fees associated with refinancing it. The tricky business of this calculation is predicting how much the up-front money would be worth upon the receipt of interest. If there are prepayment fees attached to the existing loan, refinancing becomes less favorable because of the higher cost to the borrower.
Refinancing works by giving the borrower access to a new mortgage loan, which replaces the existing one. The details of the new loan can be customized, including the new loan’s mortgage rate, time period, and the amount borrowed. Refinances can significantly reduce mortgages payment, provide access to cash for home improvements, and cancel mortgage insurance premiums, among other benefits.
So, in very basic terminology, getting a new loan in place of the original loan is refinancing. Thus, the objective of refinancing a loan is to replace an existing loan with a new loan with better terms. In other words, you get a chance to restructure your loan with a new lender and change the loan terms in your favour. While most lenders follow their own refinancing process, a typical refinancing looks something like this:
Step 1: You have an existing loan that is burdensome upon your finances.
Step 2: You come across a loan with better terms and apply for it.
Step 3: The new loan pays off your existing debt in full.
Step 4: Your new and improvised monthly payments take care of this new loan.
How is Refinancing Helpful?
Refinancing has several potential benefits, such as:
- Saving money or credit
A common reason for refinancing is to save money on interest costs. In order to do so, a person typically needs to refinance into a loan with an interest rate that is lower than the existing rate. Especially with long-term loans and large amounts, lowering the interest rate results in significant savings.
- Reducing payments
Refinancing can take the weight of those giant EMIs off your shoulders, resulting in easier cash flow management and more money available in the budget of your monthly expenses. When you refinance, you simply restart the loan clock and extend the amount of time you’ll take to repay a loan. Since your remaining debt is likely to be smaller than the original loan and you have more time to repay, the new EMI amount automatically decreases.
- Shortening the loan term
Instead of extending repayment, one can also refinance the loan into a shorter-term loan, and hence, get rid of the debt much more quickly.
- Consolidating debts
If a person or a company has multiple loans, it makes sense to consolidate them into one single loan, especially if a lower interest rate is on offer. This makes it easier to keep track of the debt and make timely payments.
- Changing loan type
If a variable-rate loan is required, one might prefer to switch to a loan at a fixed rate. A fixed interest rate offers safety if the rates are currently low, but are expected to rise in due future.
- Paying off a loan that’s due
Some loans have to be repaid on a specific date, but it is possible that funds are not available for a large lump-sum payment. In those cases, it makes more sense to simply refinance the loan and take more time to pay off the debt. For example, some loans are due after just a few years, but they can be refinanced into longer-term debt after the individual has established itself and has shown a history of making on-time payments. And if you have a fluctuating rate of interest on your loan, considering refinancing to a fixed-rate loan might not be a bad idea at all.
Refinancing can turn out to be a great financial move if it results in the reduction of your monthly payments, a shortened term of your loan, or helps you build equity more quickly. In addition to that, it can also be a valuable tool for bringing your debt under control.
The Other Side: Cons of Refinancing
Financially speaking, refinancing makes good sense, but the process isn’t always so clear-cut. Several things could go wrong while you’re at it:
- Applying for refinancing can be tricky business
If there’s been any change to the income or credit since applying for your original loan, it can halt a refinancing process in its tracks. Furthermore, income and credit scores are more important than ever. Lenders are being more cautious, and tend to scrutinize your credit reports and financial information with a keen eye. This might lead to disapproval of your request, and even if it does go through, you might end up paying interest at a higher rate. The lender may also request copies of tax returns and recent salary statements to verify your income, so having them handy might be a good idea.
- Refinancing Costs
Refinancing is a costly process. Prematurely closing an existing loan will result in foreclosure charges and people are often caught off-guard when they’re required to pay these costs, which range anywhere between 3% to 6% of the remaining loan balance. Thus, hidden or ambiguous fees may end up adding to the total cost of the refinancing process.
- Collateral Appraisal
If you’re refinancing to pay off a home loan, this factor comes into immense significance. Home appraisals estimate the worth of a property, and they are inevitable when refinancing. The appraiser uses the market value, plot value, and recent comparable sales in the area to assess a home’s value, whose results can both make or break the deal.
In such cases, a low appraisal can decrease the chances of getting new loans on better terms. In the event that the property is found less than what is owed by the appraised, a lender might choose to deny your refinance request altogether.
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4 Things to Know Before Initiating the Refinancing Process
- Know your credit score
Lenders have raised their standards for the loan approval in recent years, so don’t be surprised when you find that you do not qualify for the lowest interest rates, even with a good credit score. Remember, while better credit scores automatically make your application suitable for the lowest loan interest rates, but they are no guarantee for the maximum benefits. Similarly, applicants with lower credit scores may still obtain a new loan, but the interest rates or fees they end up paying inevitably tends to be higher.
- Know the Debt-to-Income ratio
If you already have a loan, you may assume that one can get a new one without much hassle or delay. But like with credit scores, lenders have also raised the bar and become stricter with debt-to-income ratios. While factors such as a high income, long and stable job history, and substantial savings help boost your case, the idea is to keep the payments (EMIs) under a maximum of 28-30% of your gross monthly income. In order to avoid being rejected on that basis, you may want to pay off some of your existing debt before applying for refinancing.
- Know the rates and term
While many borrowers focus on the interest rate when refinancing, it is equally important to identify and establish your goals to determine which loan meets your needs. If you aim to reduce your monthly payments, you should look for loans with lower interest rates for the longest term. If you’re going to pay less by way of interest over the length of the loan, look for the ones with the shortest terms. Similarly, if you want to pay off the loan as fast as possible, you should look for loans with the shortest terms that require payments you can afford without burning a big hole in your pocket.
- Know your taxes
Your credit score or the interest rates are not the only concerns you have while refinancing your loans. Once you refinance and begin paying less by way of interest, you will also pay more taxes. Although very few people view that as a reason to avoid refinancing, it stands irrefutable. The total interest deduction is usually higher for the first few years of the loan. Increasing the size of your will also affect the amount you will pay by way of taxes.
Like any other financial transaction, refinancing is a complex process and requires due diligence on the part of consumers considering it. Jumping on the bandwagon is not a good idea, and becomes more so in the case of refinancing a loan. You should be absolutely sure of your reasons and vision, and the ‘why’s and ‘what if’s should’ve been dealt with. It’s often considered wise to consult a reputable lender or finance experts for answers to your concerns. This goes a long way in helping one to make critical decisions as to whether refinancing is right for their concerned situation.
To sum it up, refinancing is an action for better survival, and if used properly, it will go a long way in your journey of saving resources and managing finances. Well, considering the precarious nature of financing, it is apt to remember another quote by Barbara Corcoran, as it gives us a fair idea about what refinancing essentially is:
“Refinancing doesn’t reduce your debt; it just restructures it, so be clear about what you want to achieve with a refinancing.”
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