Refinancing a personal loan can lower your payments and save money if you know how to compare your options
All you ever hear about on personal finance blogs is debt payoff but is there another way to manage your debt?
Is there a way to lower your monthly payments, save on interest AND not fall deeper into the downward debt spiral of death?
While you usually only hear about refinancing a loan when talking about mortgages, there are a lot of reasons to consider refinancing your personal loans. In fact, it could be the most strategically-smart thing you do for your credit.
Why Would You Refinance a Loan?
There’s a reason why we usually only hear about refinancing as an option on mortgage loans. On long-term home loans, it’s likely that you’ll pay off tens of thousands over a decade and may still have decades left on the loan.
That means a refinance can lower your payment by hundreds or even get you a little cash in the process.
But there are just as many reasons to consider refinancing a personal loan.
- You get a better deal on a new loan. Interest rates might have changed or you find a website that offers lower fees and a longer repayment schedule.
- Maybe you need lower payments because of income loss or you just want to free up a little monthly cash. Refinancing your loan on a longer term will lower the payment even if your rate stays the same.
- You’ve improved your credit score. Working on your credit score for even a year can significantly improve it and get you better rates on new loans.
These aren’t the same reasons you might consider a debt consolidation loan though the two topics do overlap.
With a consolidation loan, you’re paying off several loans with one new loan. This is usually going to increase your credit score by removing revolving debt like credit cards from your report and improving your utilization ratio.
The real power in refinancing an unsecured loan is in the change in interest rate and monthly payment.
What Happens When You Refinance Your Loan?
There are a couple of ways you can approach a loan refinancing and that’s going to affect what happens.
You can either refinance your loan with the same lender or go with a different lender. If you refinance with the same lender then they will probably automatically apply your new loan proceeds to pay off the existing loan and then deposit the rest into your bank account.
If you refinance with a different lender, they’ll just deposit the full amount into your account. That means it’s your responsibility to pay off the old loan. That’s hugely important and we’ll go into the process below.
If you do refinance with a different lender, it might cause your credit score to drop a little depending on how long it takes to pay off your old loan. Most creditors report to the credit bureaus once a month so if they report that balance after you’ve taken out the new loan, it’s going to look like you have a lot of debt out there.
The drop in your credit score shouldn’t be much and your score should start to increase as soon as you pay off the old loan.
Another benefit to refinancing a loan is that it could free up some cash for a month, even if the payments are the same. You’ll usually get a grace period of one month before you have to start making payments on the new loan and you’ll pay off the other loan so that means no payments for a month.
Can You Refinance a Personal Loan on Bad Credit?
It can be tough getting a personal loan on bad credit and refinancing can be all but impossible.
That doesn’t mean you should try though.
It depends on how bad your credit score was to begin with but waiting at least a year to refinance your loan can mean a huge change in your rate and payments. Most personal loan sites for bad credit borrowers stick you with an interest rate of 24% to 36% if you have a 600 FICO or less.
That means increasing your score by making regular payments on your loan, reducing the outstanding balance on credit card debt and using a few other credit hacks can save you a lot of money.
Lowering your rate by just 5% means saving $6,700 on a $15,000 loan with an original rate of 24% and can save you years on the payoff.
How to Refinance a Loan to Save Money
Taking advantage of a loan refinance means understanding the process and how to get a better deal.
The first step is going to be to check your credit score and compare it with when you got the original loan. Most credit cards will offer a free credit score service or you can get your credit report and score for $1 from TransUnion.
If you’ve increased your credit score more than 20 points since getting your loan, there’s a good chance you’ll qualify for better rates on a new loan and can lower your payments.
- Make sure to compare several personal loan sites on rates and fees. Most sites will do a soft-check of your credit which doesn’t affect your score so you can apply to a few to find the best deal possible.
- Use a debt payoff calculator to understand how much interest you save with the new loan.
- Consider all costs when you refinance. An origination fee of more than a few percent can wipe out any benefit to refinancing.
- Understand that if you refinance your personal loan on a longer-term, you might end up paying more in interest even on a lower rate. It’s best to plan on paying off your new loan in the same amount of time that’s remaining on the old loan to avoid being trapped by the debt.
- Make sure you pay off your old loan if you refinanced with a different lender! Seriously…don’t let this put you deeper in debt!
- Check your credit report after a couple of months to make sure the old loan account is closed on your report.
Costs of Refinancing an Unsecured Loan
It’s absolutely critical you understand the costs of refinancing a loan as well as the benefits. Knowing how to compare your old loan with new options will help you make a better decision and will ultimately mean saving money or losing it.
Origination fees are where I see most people misunderstand new loans and refinancing. These are take out of your loan proceeds before you get the money. That’s an important point for two reasons.
- You’ll have to ask for more on your new loan to have enough left over after fees to pay off the old loan.
- Just because your rate or payments on the new loan are lower won’t make it a good deal if the origination fee wipes out the benefits.
Divide your origination fee by the number of payments on your new loan to see how much it adds to your monthly payment. This is a good way of comparing your old loan with the refinancing. If you’re still saving money on the new loan even after adding the origination fee then it could be a good deal.
Most personal loans don’t come with annual fees but enough of them are out there that you have to watch out. Avoid any loan with a yearly fee beyond your regular monthly payments.
Most personal loans also don’t include an early repayment fee but it’s another one you have to watch for, on both the new loan and your existing loan. Having to pay a fee beyond the debt payoff on your old loan could wipe out the benefits.
Always avoid any loan that includes a pre-payment fee. You want as much flexibility as possible when using debt.
Refinancing a loan isn’t just for mortgages and the strategy can save you thousands on a personal loan. Work on increasing your credit score for a year, especially if you have bad credit, and then refinance your personal loan to save on interest and lower your monthly payment.
About the Author
Joseph Hogue is a financial expert and investment analyst. After serving in the Marine Corps, he started his career investing in real estate before becoming an investment analyst for some of the largest private investors. He's appeared on Bloomberg and on CNBC as an investment expert and has published ten books in personal finance. Now he helps investors reach their financial goals and invest in the stock market with some of the same advice he used when working for the rich.