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What Does Refinancing Really Mean, and Should You Do It?

Apr 26, 2021

As we continue to navigate the pandemic, many people are looking for ways to better manage their finances, and that includes trying to cut down on expenses in any way possible. This can be done on a smaller scale by implementing a new budget or tweaking savings tactics, which can make a difference in managing daily finances, or you can do this on a larger scale by refinancing an outstanding loan you may have.

Refinancing can seem daunting, especially if you’ve never done it before, don’t fully understand what it means, or aren’t sure when the right time to do it is. We’ve compiled some information on refinancing, as well as some considerations for those starting to explore the possibility of renegotiating any loan terms.

So, what does “refinancing” really mean?

Refinancing means you are revising or replacing the terms of an existing credit agreement, usually as it pertains to a loan (e.g. car loans, student loans) or mortgage. Your lender will reevaluate your credit terms and financial situation to make (ideally favorable) changes to your interest rate, payment schedule, or any other terms outlined in the contract. If you’re approved, you, as the borrower, will have to sign a new agreement to take the place of the original.

Should you refinance?

Most borrowers typically refinance when the interest rate environment changes substantially (i.e. when interest rates fall), which, with a new agreement, can lead to potential savings on debt payments. People with an adjustable interest rate who are looking for more consistency or predictability may want to consider refinancing to convert to a fixed interest rate. However, if you convert to a fixed-rate mortgage and interest rates drop again, you won’t benefit unless you refinance again. Refinancing in favor of an ever-changing environment can be a slippery slope, so keep this in mind when considering your options.

Ultimately, you should consider refinancing if the new terms are significantly better than your existing terms. For example, if your existing loan is too expensive or too risky, or if your financial circumstances have changed since you first borrowed the money and more beneficial loan terms are now available to you, now is a good time to consider refinancing. If all the right factors align with renegotiating your terms, you could potentially lower your monthly mortgage payment and interest rate, especially if you qualify for a lower rate based on market conditions or an improved credit score, factors that weren’t in place the first time you borrowed.

But, if you do refinance, you must be confident that the refinanced loan has better terms and features to ensure the process is worthwhile.To determine this, do a break-even calculation to see how long it would take the savings from refinancing to exceed any associated costs (i.e. closing costs, etc.).

Do your due diligence to crunch the numbers before starting the process, because if you’re refinancing a larger loan like a mortgage, you may not wind up even staying in the home long enough to reap those savings.

Let’s talk about how to refinance

Before taking the first formal step, make sure you have an idea of what your current credit score is, as this will play a big role in deciding whether or not you qualify for the lowest rates—the higher your credit score, the better.

If you’re confident that you’re a good candidate to refinance so far, you’ll have to approach either your existing lender or a new lender with the refinance request and complete a new loan application. If you had a positive experience with your existing lender, consider reaching out to them first to see if they’re willing to renegotiate the deals of your loan.If you choose to shop around for a new lender, identify 3-4 solid options before narrowing it down to the one that offers better loan terms than those in your existing loan. It’s important that you don’t settle when selecting a lender, and that you only apply for the new loan once you’ve identified the best lender for your circumstances.

Things to keep in mind before making your decision

While refinancing on a mortgage, specifically, can bring favorable changes to your agreement, it could lower the amount of equity you have in your home, which can have other implications down the line. Also, if refinancing a mortgage, you’ll have to pay closing costs on the refinance, which could add up to thousands of dollars. In addition, your monthly payment could actually increase if it’s a shorter loan term, or, if your loan term resets to its original length, the total interest payment over the life of the loan could outweigh what you’re saving with the lower rate.

In addition to paying closing costs, it can be expensive to refinance due to various costs that are different depending on each lender and state. You should be prepared to pay anywhere from 3% to 6% of the outstanding principal in refinancing fees, which can include application, origination, appraisal, inspection fees, and other closing costs.

You can adjust certain terms of a loan when you refinance, but two factors will not change: you won’t reduce or eliminate your original loan balance, and your collateral must remain in place. Be sure to consider the impact of all of these potential consequences before you make your decision, as there are many pros and cons associated with both making the decision to refinance, and making the decision not to refinance.

Erin Elis 
Erin Ellis
Accredited Financial Counselor ®
Philadelphia Federal Credit Union
eellis@PFCU.COM
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