When you take out a loan or mortgage, you agree to pay back the loan at a specific interest rate over a specific time frame. Almost immediately, it seems, you’ll start getting mail suggesting that you should refinance your loan.
What is refinancing, what are the pros and cons, and should you do it? Let’s take a look at loans and refinancing in more detail below.
What is a Loan?
A loan occurs when one party (for instance, a bank) lends you money to purchase something usually tangible, like a house or car. That money is the principal. The lender may include an interest rate and/or finance charges. The principal plus the interest are repaid over a certain length of time.
There are many types of loans and each loan can be a combination of those types.
- Secured loans require some sort of collateral, like a car
- Unsecured loans include credit cards and signature loans
- Revolving loans can be spent, paid off, and then respent
- Term loans are paid off over a defined time frame
- Simple interest loans involve the daily interest rate times the principal times the number of days between payments
- Compound interest rates mean that you will pay interest on interest. This is common with credit cards that are not paid in full
- Mortgage loans are very complex loans with a lot more terms and factors
- Conventional mortgages
- Conventional – within maximum amount set by Fannie Mae and Freddie Mac
- Non-conventional – Any loan that is funded by the government
- Jumbo mortgages – large loans over $510,400
- Government-insured mortgages
- FHA – borrows without a large down payment
- USDA – rural areas
- VA – military
- Fixed-rate – set rate loan
- Adjustable-rate – variable rate loan
- Interest-only – only pay interest for 5-7 years and then higher payments
- Balloon mortgages – lower payments with the remainder due at end of term
- Conventional mortgages
Now that we have discussed loans, let’s discuss refinancing. There are some very good reasons to do it.
What is Refinancing and How Can it Help?
Interest rates fluctuate based on economic conditions. If you have taken out a loan at a higher interest rate, you may save a huge amount of money by lowering your interest rate. If you have an ARM, you may be able to lock in a better interest rate before the interest rate increases.
Lowering monthly payments is another benefit of refinancing, especially if you get a far lower interest rate. It can also shorten the duration of your loan as you pay it off more quickly.
If you have equity built up in your home, you can take out a loan that includes some of the equity and get cash out. For instance, if you have a house worth $100,000 and equity of $40,000, you can take out a loan for $100,000 and pay off the $60,000 remaining mortgage and have $40,000 leftover for upgrades, college, or other expenses.
Streamlining finances is another benefit to refinancing. You may be able to roll all your debts into one loan and then refinance that loan as the interest rates vary. Paying off higher interest student loans is always a good idea.
What To Consider Before Refinancing
Before you refinance a loan, you should take into consideration a number of questions. Most people consider refinancing mortgages because they are the largest loan most people will ever have. We’ll consider refinancing a mortgage, but the questions remain the same.
- Why are you refinancing? Are you trying to get a lower interest rate, shorten your loan duration, or get cash for a home to pay off other loans?
- What is the current interest rate? Is it significantly lower than the one you have now? Will the savings offset the cost of refinancing?
- Are you comparing rates to comparable rates? ARM rates look great in the beginning when compared to most fixed interest rats, but they have the possibility of rising rapidly at the end of the loan.
- What is your credit score? The better your credit history, the better your loan rates will be.
- What is your debt to income ratio? The better it is the better your rate will be.
- Is your home’s equity high enough to make a cash-out possible (if you want one)
- What are the closing costs and can you pay them up front?
- What is the breakeven point? Divide your monthly savings by closing costs to see when you will break even. If it is before you plan to sell, it may be a good opportunity.
- Mortgage Insurance – you may be able to drop your mortgage insurance if you have enough equity.
- What is your new term? A shorter-term will be more than a longer-term, but you will save on interest. Trading a 30-year loan for another 30-year loan may not make a huge difference for your long-term finances.
Pacific Debt, Inc
Buying a home with bad credit or a terrible debt to income ratio is an almost impossible task. Getting a decent loan rate with bad credit could be equally hard. If you have bad credit and excessive debt, you may need someone to help you find your way out of debt without obtaining a new loan, Pacific Debt can help.
If you have more questions, contact one of our debt specialists today. The consultation is free, and our debt experts will explain your options to you.