Maine Credit Unions recently created a new Member Moment video that highlight the benefits of refinancing. The latest Financial Literacy Blog dives into this topic as well, covering the pros and cons with certain scenarios. Credit unions are encouraged to post Member Moment videos on their social media feeds and can share the Financial Literacy Blog with their members.
(From Financial Literacy Blog) – The Pros and Cons of Refinancing
Refinancing is the process of revising and replacing the terms of an existing credit agreement, usually in the form of a loan or mortgage. To simplify things, when you refinance, you’re replacing an existing loan with a new loan that pays off the debt of the first one. People refinance loans for a variety of reasons, but most go through the process in order to obtain more favorable borrowing terms. Benefits of favorable borrowing terms can include a lower interest rate, lower monthly payments, and shorter repayment periods. While there are many advantages to refinancing existing loans, you could be putting yourself at a disadvantage in certain scenarios. Here are the pros and cons of refinancing an existing debt:
Paying Less Interest
If you had poor or no credit when you initially took out a loan, it’s likely you were given a higher interest rate. If your credit has since improved, you may qualify for a lower interest rate when refinancing. An interest rate is the amount a lender charges for the use of funds expressed as a percentage of the original loan. The lower the interest rate, the less someone will pay over the life of a loan. For example, let’s say you take out a $20,000 auto loan at 10%––with a repayment period of five years. After paying $424.94 every month for a year, you decide to refinance at a new rate for the remaining four years. If you refinance the remaining $14,900.72 at 4%, your new payment will be $335.77 per month, for a monthly savings of $89.17. By the time you finish paying off the loan, you’ll have saved a total of $4,280.16 by refinancing.
Lowering Monthly Payment
Like in the scenario above, a lower interest rate on your refinanced loan can lead to lower monthly payments––freeing up funds to pay off other higher-interest debt. Alternatively, you could build up an emergency fund or save the money away in a retirement account. To see an even further reduction in your monthly payment, you can extend the term of your loan when you refinance. While you would have lower monthly payments, it may mean you’d be paying more in interest over the life of the loan, which could become a con in the long-run.
Paying Your Loan Off Sooner
If you have student loans, a car payment, or a mortgage, you can always go the route of paying extra on top of your current payments to pay the loan off sooner. This is known as paying extra on principal. Principal is the loan amount before any interest. Instead, if your credit has improved, refinancing with favorable terms can help you streamline the process and maximize savings.
You Might Have to Pay Fees
Some lenders charge a prepayment penalty for paying loans off early. This is to incentivize borrowers to pay back their principal slowly over a longer term, allowing the lender to collect more in interest. This is more common with mortgages than other types of loans. By refinancing, the original lender may charge the penalty. Some refinancing lenders also have application fees, though not common. If the lender does, compare the total amount of fees with how much you’d be saving by refinancing. If the fees add up to more than your savings, refinancing wouldn’t make sense financially.
You Could Pay More in Interest
If you stretch your loan payments over a longer term to save money each month, you may end up paying more interest over the life of the loan––even if it’s at a lower interest rate. While a reduced rate will often result in lower overall costs, a few extra years of interest on payments can add up.
You Could Lose Federal Benefits
If you have federal student loans, refinancing might not be the best idea––despite more favorable terms. When you have federal student loans, you may be eligible for federal benefits. These benefits include forbearance or even student loan forgiveness. For example, since March of 2020, federal student loan borrowers have been eligible for forbearance. This means no payments have been required since and all the interest rates on student loans were automatically set to 0%. Further, most student loan forgiveness programs are only available to borrowers with federal loans, not private. By refinancing a federal student loan, it becomes a private loan.
Weigh the Pros and Cons
It’s always a good idea to weigh the pros and cons of refinancing before you make any decisions. Under the right circumstances, refinancing can save you a lot of money. If you plan to refinance, know your goal––whether it be lowering your monthly payment or paying your loan off sooner. Next, use a refinancing calculator to compare your current loan with a refinancing offer to determine which is the most cost-effective.
For questions about refinancing or to inquire about their favorable rates and terms, contact your local credit union.