What Does It Mean To Refinance a Loan?

Refinancing a loan allows borrowers to replace their existing loan with a new one, typically with better terms. If you refinance, you can lower your interest rate, reduce monthly payments, or change your loan terms. In some cases, such as cash-out refinancing, you can also borrow additional funds.

You typically must meet lender requirements to qualify for a refinance loan with better rates than your current loan. Understanding the requirements, benefits, and your credit standing can help you determine whether it makes sense to refinance an existing loan. 

What is loan refinancing?

Loan refinancing occurs when you take out a new loan to pay off an existing one. The new loan typically has different terms, such as a lower interest rate, an extended repayment period, or adjusted monthly payments. 

You can refinance into a lower interest rate to save money, manage debt, or access cash for other financial needs.

How does refinancing a loan work?

The refinancing process differs depending on the lender and loan type but typically involves these steps: 

1. Submit application: The refinancing process starts when you apply for a loan to replace your existing one. The lender reviews your credit history, income, and financial standing to determine eligibility and set the loan rate and terms. 
2. Pay off old loan: If you are approved, the lender pays off your original loan and issues a new loan, often with a different rate and repayment period. 
3. Start making new payments: Once the new loan is issued, you begin making payments on the new debt under the agreed-upon terms. 

Types of loans that can be refinanced

Many different types of loans can be refinanced, including: 

• Mortgage loans: If you have a mortgage, refinancing your home loan can help you adjust your rate and terms or tap into your home equity. 
• Student loans: Both federal and private student loans are eligible for refinancing. However, refinancing federal student loans may result in the loss of certain borrower protections. 
• Auto loans: You can refinance your auto loan, depending on the loan balance and value of the vehicle.
• Personal loans: These unsecured loans are often used for debt consolidation, major expenses, or emergencies. Options vary, so check if your lender offers refinancing for personal loans. 

Pros and cons of refinancing 

Refinancing offers several potential benefits and risks: 

Pros 

• Lower interest rate: One of the most common reasons for refinancing is to lower your interest rate. You can reduce your overall borrowing costs if you can secure a lower rate.
• Lower monthly payments: Some lenders let you extend your loan term, spreading your payments over more time. This can be an option if you want to lower your monthly payments and improve cash flow.
• Updated loan terms: You may be able to lengthen or shorten your loan terms when you refinance. For example, lenders may let you switch from a variable rate to a fixed one for more predictable payments. 
• Accessing equity or cash: If you’re a homeowner with significant home equity, you can use a cash-out refinance to access funds for home improvements, debt consolidation, or other expenses. 

Cons

• Costs and fees: Refinancing may come with additional expenses, such as closing costs, origination fees, and prepayment penalties, which can impact your overall savings. 
• Extending the loan term and paying more interest: Extending your loan term lowers monthly payments but can also cost you more interest over the life of your loan. 
• Losing existing benefits or protections: Some loans, like federal student loans, offer benefits such as income-driven repayment plans and forgiveness. Refinancing into a private loan removes federal protections.

What to consider before you refinance

Whether it makes sense to refinance your current loan depends on your financial situation and borrower profile, among other factors. 

Current financial situation

Assess your income, expenses, and overall financial health to determine if you qualify for better terms. Make sure you can afford the potential closing costs and new monthly payments. Also, consider whether refinancing aligns with your long-term financial goals.

Credit score and history

A higher credit score can make you eligible for better terms. Check your credit score to see if you can qualify for better interest rates. Review your credit report for errors that could hurt your credit profile. If you find any errors, file a dispute with the credit bureau to correct the mistake. 

In some cases, such as when refinancing student loans, you may need to apply with a cosigner to qualify for a new loan. 

Market interest rates

Interest rates fluctuate based on market conditions. Refinancing when rates are lower could save you money in the long run. 

Loan terms and conditions

Compare loan terms carefully to make sure the refinanced loan provides better benefits than the existing one. 

Steps to refinance your loan

The refinancing process can vary depending on the lender and loan type. Generally, expect to follow these steps: 

1. Evaluate your loan and financial goals

Review your loan terms, interest rate, and repayment schedule to determine if refinancing could improve your situation or allow you to reach your goals. Check your credit score before you submit any applications. Lenders use your report to assess your eligibility and interest rates, so make sure you know what’s in your report ahead of time.

2. Shop for lenders and compare offers

Research multiple lenders to find the refinancing option that best fits your needs. In many cases, you can find out what rates you’re eligible for without a hard credit inquiry. When comparing options, pay attention to each lender’s rates, terms, fees, and eligibility requirements.

3. Apply for a new loan

Once you've chosen a lender, submit your application and all required paperwork. If approved, you must accept the loan terms and conditions. Then, the lender will pay off your existing loan, and you'll begin repaying your refinance loan. If it's a cash-out refinance, the lender will disburse your funds.