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Loan Refinancing 101

Life happens. Sometimes we have to borrow time with borrowed money.

At one point or another, almost everyone is apt to apply for a loan to cover a considerable financial expense. Especially when said expense extends beyond the total in our checking and savings accounts.

But, sometimes, these financial obligations can crop their heads up at inopportune times. For instance, maybe you’ve had to take a loan out when your credit score was less than stellar. Consequently, your high-interest rate may reflect your low credit score. Or perhaps you opted for a lengthier loan term five years ago that you’re now capable of paying off faster. Or you may have many small loans, and, let’s face it, keeping track of a plethora of monthly payments can be annoying and confusing. Instead, you’d like to consolidate those small loans into one big loan.

If any of these scenarios hit a little too close to home, refinancing may be an option worth considering.

What is it?

Refinancing is the act of taking out a new loan to pay off the debt of another loan(s). Once the loan is approved, the new lender will pay off the borrower’s original loan. The borrower is then responsible for the new rate and payment schedule of their new loan.

Loan refinancing is a popular route taken to tackle student loans, auto loans, home loans, and credit card debt. And there are quite a few benefits worth reaping from doing so.

Why refinance?

For starters, loan refinancing can save you money.

Let’s say you have two different student loans of about $15,000, and those loans have a fixed interest rate of 10%. If your loan term is 15 years, you would ultimately end up paying around $29,000 for each loan by the time you’ve paid them off. That’s because the principal balance of each loan is $15,000, and the interest amounts to $14,000. Multiply that by 2, and you’ll be paying $58,000 for the combined total of your student loans. What’s more is that your monthly payment for each loan would clock in at around $160, costing you $320 per month.

But, if you decide to consolidate your loans by refinancing them, you may be able to score a lower interest rate and end up saving a lot of money.

Now let’s say that you refinanced your two $15,000 loans into one $30,000 loan at a 5% fixed interest rate extending 15 years. Instead of paying $58,000 by the end of your loan’s term, you would pay about $42,700, including interest, which is about $237 a month.

Once you’ve paid off your single $30,000 loan 15 years later, you’d end up saving $15,300 total and $83 a month compared to paying two separate $15,000 loans!

If we consider this scenario in its entirety, you won’t just end up paying less over time. You’ll have lower monthly payments, a lower interest rate, and you will have simplified your finances.

A word of caution:

Refinancing may backfire, especially if you decide to refinance a loan to extend its lifespan.

If you have a $20,000 loan at a 5% fixed interest rate over 15 years, you will end up paying about $158/month and $28,000 total.

Refinancing that same loan for a 30-year term would entail paying less money per month (around $107). But, over time, you’ll end up paying $10,000 more in interest, totaling $38,000. Lower monthly payments may be more appealing, but buying time in exchange for lower payments is often more costly.

Of course, you may want to pay off your loan quicker, even if it means paying more per month at a higher interest rate. Ultimately, you may still end up saving money because the loan would accrue less interest over time due to having a shorter lifespan.

Whether you’re looking to lower your interest rate, pay less per month, or simplify your finances, refinancing may be right for you.

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