How to refinance personal loans – What are the pros and cons?
Everybody knows that refinancing a home mortgage can often save a lot of money. But did you know that you can also refinance a personal loan in some cases?
A personal loan can be a good way to pay off or consolidate credit card debt, starting a business, or remodeling part of your house. However, if you’ve done your homework and know the basics about personal loans, you know that there are risks involved if you fail to pay according to the agreed upon terms.
For borrowers hoping to lower payments on their personal loan or increase their loan amount, refinancing could be a very workable option. So what is it?
NerdWallet.com says that “refinancing a personal loan means obtaining a new loan and using the funds to pay off an existing personal loan. This strategy can save you money if you qualify for a lower interest rate on the new loan. There also may be other situations where it makes sense to refinance.”
Reasons to refinance a personal loan
Many people make the decision to refinance a personal loan to decrease the minimum monthly payments, decrease interest rates and find better terms for repayment in the long term. The main benefits to refinancing personal loans are:
- Lower Annual Percentage Rate (APR): This will be determined by your credit score, income and debt-to-income ratio, so if any of these numbers have improved, you might be able to qualify for better interest rates on your new loan.
- Shorter repayment period: When trying to pay off debt quickly, paying more than the minimum payment is key, which is why when you take out a personal loan with better terms of repayment, you should look for lower minimum payments. By doing this, you’ll be able to pay more than the monthly minimum, paying less interests and shortening the repayment period.
According to NerdWallet.com, refinancing a personal loan is a good idea when:
- Your credit has improved, as borrowers with good (690 to 719) or excellent credit (720 and higher) typically receive lower rates on personal loans.
- You need lower payments, even though this might mean paying for a longer time period.
- You want to pay off the loan faster, which will reduce your interests but … you guessed it! Monthly payments will be higher.
- You want to switch from a variable to a fixed rate, to provide more certainty in your budget. Not sure what kind of rate you have? Click here to learn more about fixed vs. variable.
Reasons not to refinance a personal loan
Even though refinancing a personal loan might be the best option for you, it’s good to keep in mind that this financial action could also result in a not-so-positive outcome, such as:
- More interest, as you’re basically starting a new loan which could take longer to pay off
- Origination fees, which are common when taking out a new loan, and could range from 0% to 8% of the loan amount
- Prepayment penalty when you pay off your previous loan
How will this affect my credit score?
When applying for a new loan for refinancing, there are a few ways in which this could affect your credit score. Credit Karma explains, it’s important to consider:
- Applying for a new loan will result in creditors running your credit report and a hard inquiry. If you’ve read our previous post on hard and soft inquiries, you know that hard inquiries can lower your credit score by a few points and stay on your credit report for about two years.
- Closing the previous loan doesn’t make it disappear, as some scoring models will still factor in your closed loan when calculating your average age of accounts.
- Your new loan will be added to your number of total accounts.
If you’re not sure if any of these situations apply to you, make sure to take your time when shopping lenders and ask the right questions. And be sure to ask a trusted professional advisor before making any significant financial decisions.
Finally, if you’re considering refinancing, be sure to approach your existing lender first. They already have experience with you and may be more willing to make changes to keep you as a customer.