Paying off a loan can feel like being stuck in a hamster wheel. Month after month you make your payments, and it seems like you’re not getting any closer to paying off your debt in full — the wheel just keeps spinning and spinning.
Although the best way to get out of debt is to consistently make on-time payments, not only bringing you closer to becoming debt-free but also increasing your credit score over time, there are other options available to you.
One option is to refinance your debt.
What is Refinancing?
Refinancing is essentially taking out a new loan to pay off an old loan or debt. This can include personal loans, mortgages, credit card debt, and really any other type of debt.
While it may not initially make sense to pay off a debt by taking on a new debt, refinancing can actually save you time and money in the long run.
When someone refinances a debt, they find a lender with better rates and terms than their original lending agreement. This can lower interest rates, thus lowering monthly payments, in addition to cutting down the life of the loan, allowing you to jump out of the “hamster wheel of debt” much sooner than you would have with your original debt.
Or, if you would like to lower your monthly payments even more, you could potentially extend your loan term, reducing how much would need to be paid toward your loan principal month to month.
It sounds pretty easy and straightforward, doesn’t it? And that’s the idea. But maybe some questions remain: Should I refinance my debt? Are there any drawbacks to refinancing? How do I know when it’s a good time to refinance? What is the refinancing process?
These are important questions to ask, so let’s dive into each one and make some sense of this important decision.
Should I Refinance My Debt?
In most cases, the answer to this question will be yes.
Refinancing your debt can allow you to find lower rates, including the opportunity to switch from a variable interest rate to a fixed interest rate.
This can be beneficial as a fixed rate will provide you with a specific amount that you will pay towards your loan principal each month, instead of having that amount fluctuate with the market, as it does with a variable rate.
In addition, refinancing can provide an opportunity to consolidate multiple debts into one, making it easier to stay on top of just one monthly payment instead of multiple.
This also means that you will likely have one lower interest rate, instead of multiple, higher interest rates on multiple debts.
Are There Any Drawbacks to Refinancing?
Although refinancing is generally a good idea, there are some cases when you wouldn’t want to refinance your debt.
Even though the purpose of refinancing is to help consumers get out of debt and save money, it can be an expensive venture.
Depending on which state you live in and which lender you are refinancing through, you could get hit with some fees: application fees, origination fees, etc. This may not be the case with all lenders, but it would be wise to do some homework on multiple lenders to see what fees they might charge.
Another important thing to consider, especially if you are looking to refinance student loans, is the benefits that you may lose, particularly those of federal student loans.
In general, federal student loans offer loan forbearance and forgiveness, in addition to other repayment options, that would be disregarded if you were to refinance with a private lender.
It is important to note that the U.S. Department of Education does not have any refinancing options, and so you would have to do so through a private lender, many of which do offer federal student loan refinancing.
If you are looking to refinance large debt, such as a mortgage or home loan, it is important to recognize that there are increased variables to consider, such as collateral or equity. In some cases your collateral could be seized, or if you choose to cash out part of your equity, your new mortgage loan will likely have a higher loan amount.
With both the pros and cons in mind, you’ll want to assess your needs and situation while also considering the type of debt you’re looking to consolidate. If you have diligently made on time payments towards your original debt, your credit score has likely improved, increasing the chance that you could receive more competitive rates and terms should you choose to refinance.
How Do I Know When It’s A Good Time to Refinance?
This can be a difficult question to answer, as there isn’t really a blanket response for everyone. But there are some factors that can be taken into consideration:
- Credit score improvement: In general, lenders report your activity and payment history to the major credit bureaus: Experian, Equifax, and TransUnion. These bureaus analyze your borrowing behavior and create your credit score. Therefore, if you’ve been making on time payments towards your original debt, this should positively affect your credit score, increasing it over time.An increased credit score, particularly an excellent one of 700+, could get you much lower rates and better terms if you choose to refinance your existing debt.If you have not been diligent in making on time payments with your original debt, refinancing may not be a viable financial solution for you.
- An interest rate drop: The Federal Reserve recently cut interest rates during the onset of the coronavirus pandemic in March. The reason why the Fed may cut rates, as was the case back in March, is to encourage consumers to continue spending and borrowing, especially if there is the risk of a financial crisis or recession.In such circumstances, or when there is an interest rate drop, that could be an indicator of a good time to refinance debt as you may be able to get significantly lower rates and terms than you would otherwise.On the flip side, if interest rates are rising, it could be a good time to refinance and get a fixed rate so you don’t get hit with higher rates later on with your original debt.
- Spending is under control: Particularly in regards to credit card debt, if your spending is under control and you’ve perhaps made a budget that you can stick to, refinancing could be a good option to look into.Also known as credit card consolidation, refinancing allows you to combine outstanding debt into one monthly payment. This could save you a lot of stress, especially if you have multiple credit cards, because you won’t have to worry about getting hit with multiple interest rates that are generally quite high.However, if you are still in a habit of overspending, refinancing may not prove to be helpful because you will still get hit with interest rates if you are unable to make your monthly payments. Overall, it wouldn’t prove to be helpful to attempt to manage your debt by falling deeper into debt.
These are just some factors that you can consider when approaching your existing debt and the question of whether or not you should refinance.
Knowing when to refinance will be entirely dependent on your circumstances and financial needs. But, an easy rule of thumb would be to assess where your credit score is at first, because that will make or break the success you could have in refinancing.
What is the Refinancing Process?
If you determine that refinancing your debt is a good option, and it’s a good time to do so, you will want to start researching your options, and lenders that are available to you.
Financial institutions, such as banks and credit unions, may have debt refinancing options available. But, online lenders are another popular option, offering quick and easy application processes.
There are many lenders to choose from when looking to refinance. When comparing lenders, some of the most important things to consider are rates, terms, and fees.
If you are consolidating debt, the rate you would get with a refinanced loan will likely be lower than having multiple debts each with their own interest rate. But, there may be additional fees to pay, as the lender is agreeing to pay off your existing debt, which could be a great risk to them.
Beyond picking a lender, your existing debt will be paid in full, and you will then have a new loan disbursed to you.
As you should have done with your old debt, make sure you stay on top of payments with your new loan, as this is the best way to save yourself from financial stress and to achieve the debt-free life you are looking for.
Final Thoughts on Refinancing
Refinancing debt is an important decision, but one that could save you money and time, allowing you to obtain a debt-free life sooner.
More than anything, keep in mind that refinancing entails jumping from one hamster wheel to another, but the new wheel should provide a more leisurely pace and the assurance that you are closer to paying off your debt.
Kalicia Bateman is a personal and education finance writer at BestCompany.com. She is a firm believer that finance isn’t as scary as it may seem, and is committed to helping consumers make positive and educated financial strides in their lives.