In the modern world, inflation has lead to booming prices of essential commodities and services like houses, automobiles, start-ups, education, etc. Availing a loan is the only solution to meet such high-end expenses when saving isn’t sufficient. Being eligible for a loan and getting it sanctioned is a huge responsibility as the individual now has to carry a burden called debt until the entire principal amount is repaid with interest. But what if we are unable to repay the entire amount within the allotted tenure then what? Is the financial company going to take over all our mortgages? Will we be debt-ridden forever? This can be avoided by resorting to loan refinancing.
After reading this article, you will be able to define what is loan refinancing, differentiate between the different types of refinance loans, know about what kinds of loans can be refinanced, know the merits and the demerits of refinancing loans, and how exactly to go about the refinancing process. So let’s read more on the topic: What is Loan Refinance? What are the benefits of refinancing?
What Is Loan Refinancing?
In this article
Loan refinancing is when borrowers are struggling to pay off a loan and vail another loan with more favourable terms. An individual may opt for refinancing its current loan due to the financial crisis he faces with the current loan. Hence refinancing the current loan with an affordable one is highly beneficial.
Refinancing revises the interest rates and tenure for the loan repayment. It is flexible as it allows the debtors to repay the amount in small qualities, thereby promoting potential savings on the debt payment.
Types Of Refinance Loans
1. Rate-And-Term Refinancing:
According to this method, the original loan is paid off, and another loan replaces it with a low-interest rate.
2. Cash-Out Refinancing:
When the assets that borrowers use as collateral become highly valuable, the individual can claim back his ownership over that asset by refinancing a loan instead of selling away the commodity. Although the total amount to be repaid will be higher, but he will still own the asset.
3. Cash-In Refinancing:
This type of refinancing allows the borrowers to pay down some portion of the loan for a lower loan-to-value ratio.
4. Consolidation Refinancing:
According to consolidation refinancing, borrowers avail a loan with an interest rate below average compared to the interest charged on other commodities. Hence the borrowers can now apply for a new loan with low interest and pay off the existing debt, thereby leaving the total debt with a low-interest rate payment.
What Kinds Of Loans Can Be Refinanced?
1. Student Loans:
A student may avail multiple loans to pursue higher studies from a reputed university. These could be private loans, subsidized federal loans, or unsubsidized federal loans, each having different interest rates. Refinancing student loans can consolidate all these loans into a single one, and now the debt will have to be repaid to a single lender with a lower interest rate.
2. Credit Cards:
We use credit cards frequently to make essential transactions. But continuous use lands us in huge debt at the end of every month, and if these debts are not cleared every month, then it will get piled up. This credit card debt with a high-interest rate can be refinanced with a personal loan, which offers a comparatively low-interest rate. Hence the debtors can avail this affordable and manageable way of repaying this huge debt instead of getting debt-ridden.
Mortgages are refinanced for two reasons: to reduce the monthly payments or to shorten the tenure. The borrowers planning to go for mortgage refinancing should be aware of the closing costs, which could be high.
4. Auto Loans:
Refinancing auto loans can enable car owners to lower their monthly payments. Details like age of car restrictions, mile caps, and outstanding balance limits are mandatory eligibility requirements while refinancing the loan.
5. Small Business Loans:
Small business owners refinance business debts to increase their profits. This could be achieved by availing loans that offer low-interest rates and low monthly payments.
Benefits Of Refinancing A Loan
a. Lowers The Interest Rate On The New Loan:
While applying for a refinance loan, one must make sure that the interest rate of the new loan should be less than the current loan with a longer-term as it could help enhance the savings of the borrower.
Suppose the borrower has availed a home loan with an interest rate of 6%, but now if he is unable to repay the debt, he can refinance the current loan with another loan that offers an interest rate of 4% to its borrowers. Thus the borrower can now save up to 2% of his amount that he used to pay earlier.
b. Change The Tenure Of The Loan:
When a new loan is availed, its tenure can either be extended to make monthly payments in small amounts so that the borrower can repay the principal amount at his convenience. Still, long durations would also mean a high interest charged in the entire duration.
Otherwise, one can also refinance a long-term loan into the short term by paying higher monthly payments, resulting in a lower interest rate over the entire duration.
c. Consolidate Loans:
If a person has availed multiple loans and is yet to them pay off, then all of them can be combined by refinancing a single loan. By refinancing a loan equivalent to the amount to be repaid, the borrower will now have to keep track of only one loan that sums up other individual loans.
d. Change The Type Of Loan:
If your current loan is a variable-rate loan that varies your monthly payments, refinancing can help change the type of loan by availing a fixed-rate loan that keeps the regular EMI payment.
The key difference between the two types of loans is that the interest rate varies in the variable-rate loan, whereas, in the fixed-rate loan, the interest rate is fixed.
e. Lower The Monthly Payment:
Due to low-interest rates, the new loan payments will be lower than the original loan; hence the monthly payment is bound to be less than the previous loan payments.
f. Pay Off The Unpaid Loan:
Some loans have to be repaid on a specific date. But of borrowers don’t have sufficient funds to repay the huge lump sums, then they can refinance the loan to avail an affordable one with low-interest rates and low monthly payments. So now they have more time to repay the refinanced loan.
Demerits Of Refinancing A Loan
After going through the benefits, everyone may consider refinancing a loan is the best choice, but there are a few drawbacks that one should consider before refinancing a loan.
1. Transaction Costs:
Although refinancing increases the potential savings of the debtors, it can also be expensive. Apart from the principal payments, there are refinancing fees, which include application, origination, appraisal, inspection fees, and closing costs. For large loans like home loans, the closing costs are really high.
2. Higher Interest Costs:
With low-interest rates and longer tenure as compared to the original loan, the refinanced loan could become cumbersome when monthly payments are not made regularly, thereby delaying the payments. This would ultimately extend the tenure, thereby increasing the interest rate paid over the entire term.
3. Lost Benefits:
Some loans offer useful benefits when available, but if they refinance the loan, these benefits will be eliminated.
What Is The Procedure To Refinance A Loan?
Refinancing a loan is similar to shopping. When we go shopping for an electronic device, we always inspect the commodities thoroughly for its quality, condition, warranty, power consumption, and other factors before buying it.
i. Always take care of issues related to the credit and ensure that you have a high credit score to avail loans at the lowest interest.
ii. One should always have an idea about the rates and terms that he desires while refinancing a loan, and these amenities should be better than the ones offered by the current loan.
iii. Check for qualified lenders offering loans with the best terms which are favorable to your conditions. If your current lender wishes to keep your mortgage, then you may get better returns.
iv. While refinancing a loan, do not make any other investments or open new credits that may disrupt your new loan. And make sure you are aware of all the new terms and associated fees so that you are financially prepared to make all the necessary payments.
Related Frequently Asked Questions
1. What is a variable-rate loan?
A variable rate loan also called as the floating-rate loan is a kind of loan wherein the interest rate varies periodically over the entire term of the loan. Lenders have a base rate which determines the monthly payments to be made by the borrowers but as the interest rate fluctuates the payments are likely to increase or decrease up to the base charge.
2. What is a fixed rate loan?
These are the loans offered at an interest rate which is predetermined at the time of sanctioning. Hence the monthly payments will be stable for the entire term of repayment irrespective of the market conditions.
3. Can I switch from a floating rate to a fixed-rate loan?
Yes, through refinancing borrowers can change their loans from the one that offers a floating rate to a fixed rate. However, there are several fees and costs involved in this procedure.
4. What is the amount of equity needed to refinance?
The amount of equity needed to refinance a loan depends on the type of loan and the lender. For refinancing a mortgage loan many lenders require equity of 20% whereas some banks require not more than 5% of equity.
5. What are the costs associated with refinancing?
Refinancing a loan involves several closing costs ranging from 2 to 5 per cent of the loan balance. If borrowers can’t afford these costs then the lenders may charge high-interest rates in exchange for the closing costs. This further increases the total amount the borrowers owe to the property.
6. Is a good credit score a decisive condition for refinancing?
Refinancing creates a new loan. Hence in order to avail it, you have to complete your new application and the lender will check your monthly income and credits for eligibility requirements. If you have a low credit score then your application is bound to be rejected because lenders require high credit scores for loans.
7. Do I have to refinance with my current bank?
That’s not mandatory although there are several benefits associated with refinancing with the current lender. However, if you have been a good customer by pay off your monthly dues on time then they may offer the best rates and waiver the closing costs to retain you as the customer. But it’s better to compare the costs with at least two banks to ensure that you can enjoy the best deals.
8. Can I refinance loans more than once?
Yes, as long as you have a good credit history and you meet the eligibility criteria of the lender you can refinance loans time and again.
9. When is the appropriate time to refinance a loan?
The best time to refinance is when you have a good history of earnings and your credit score is high. This will enable you to avail a loan with a low-interest rate. If you do not qualify in the first attempt then enhance your monthly income and improve your credit score to be eligible in the future.
10. Can I consolidate my loan with my spouses?
No, consolidated loans comprise of the loans that only you had applied previously. However, you and your spouse can refinance your individual loans separately.
11. After refinancing my loans, can I pay extra on the loan in a given month if I am able to pay it off quicker?
Yes, there are no payment penalties while paying off a new loan.
We humans, as consumers, use a lot of services available in the market. They may often not have sufficient funds to avail of these facilities and may end up taking loans to do so and failing to repay these loans results in debt, which may even last life long unless cleared. But what if the borrowers are unable to do so due to financial distress. Refinancing a loan is the best option for borrowers who wish to improve their financial conditions by availing low-interest rates, low monthly payments, converting the floating-rate loan to fixed-rate, and consolidating previous loans. Refinancing loans enable borrowers to enhance their overall savings as one often tends to pay less towards a loan that has just been refinanced. This helps the borrowers get rid of all the debts permanently, improve their credit score, and achieve financial stability.