What happens when I “refinance”?
“What is refinancing? I hear people talking about refinancing their home, their student loans, but what is refinancing and how does it work?” We frequently hear a version of this question and it’s a good one. People are told they should refinance, they hear friends and neighbors talking about it, but what exactly is it?
Refinancing is just swapping out an existing loan (or loans) for a new loan.
You use the money you borrow in the new loan to pay off the old loan. That leaves you with just one loan, ideally with a better interest rate, lower monthly payment, or other improvement over the old loan.
Here’s a quick example. Let’s say you owe $14,000 on your car loan with an interest rate of 9.5%. You check out refinancing options and see you qualify for a rate of 5.5%.
When you refinance you borrow $14,000 with a rate of 5.5% then use that $14,000 to completely pay off the existing loan with a rate of 9.5%.
You’ll pay a lot less in interest paying 5.5% interest instead of 9.5% – good work!
You’ll hear a lot more about refinancing when interest rates fall. That’s because most loan rates tend to move up and down more or less in line with interest rates in general. If rates have fallen since you’ve taken out a loan, there’s a good chance you could refinance and save some money. On the other hand if rates have been rising since you took out a loan, you’re unlikely to get a better rate by refinancing.
This isn’t always true though! If your credit has improved, or you’re applying for a promotional interest rate (like with a balance transfer card) you may be able to improve your loan terms by refinancing even if overall rates haven’t moved in your favor.
When considering refinancing it’s important to remember that it isn’t free.
There will almost always be a transaction cost. That cost is often a percentage of the amount refinanced, but it could be a flat fee. You should always weigh the potential savings from refinancing with the cost of the refinancing itself. It may not always be worth it; even if you can improve your rate somewhat it may cost you more to complete the refinancing than you would save.
If you’re curious about some more specific types of refinancing, and why it might not always be a good idea, check out our articles about student loan refinancing and home (mortgage) refinancing.