A refinance loan is a type of financing that is used to replace one or more existing loans with a new loan. Though there are many reasons to refinance, loan borrowers typically consider refinancing their current loan in order to lower the payments, adjust the term or increase the loan amount.
During periods of relatively lower interest rates, many borrowers take advantage of the opportunity to lower their loan payments with a loan refinance. This is particularly true for homeowners with very large mortgage loans.
For example, a borrower obtained a mortgage loan of $200,000 two years ago based on a 30-year term with a five percent (5.00%) interest rate. The monthly payment for the loan is $1,073.64. If current interest rates drop to three percent (3.00%), the borrower could see dramatic savings with a refinance to a new loan at a lower rate.
The monthly payment on a 30-year, $200,000 loan at three percent (3.00%) interest would only be $843.21. By refinancing to that lower rate, the borrower can reduce his or her payments by $230.43 per month – or $2,765.16 per year.
But borrowers can lower their interest rates and payments even when the general market hasn’t improved since they originally took out their loans. For example, borrowers with less-than-ideal credit records or very low credit scores may have to accept higher interest rates on their car, mortgage or personal loans. If they have rebuilt and improved their credit record, their improved credit and higher scores may allow them to refinance to the lower rate offered to borrowers with very good credit.
Unfortunately, many borrowers fail to realize that there’s also a downside of refinancing to a lower interest rate. Although it can lower monthly payments, some refinances may actually end up costing the borrower more over the long run.
In the above example, the borrower loses the two years of mortgage payments already made when refinancing to another 30-year loan:
Not including any refinance finance charges and closing costs, it would take the borrower over four years the loss of two years of interest already paid – if that borrower refinanced to another 30-year loan. If the borrower sells this home in under four years’ time, then the refinance would actually have produced a net loss.
The obvious solution is to refinance to a 28-year loan (or shorter term), instead of another 30-year loan.
Over the long run, the best way to save money through a refinance is usually by reducing the loan’s term.
Changing the loan term affects the amount of interest the borrower is required to pay. Using the same example, over the life of a 30-year refinance loan of $200,000 at 3 percent interest, the borrower will pay $103,354.90 in interest over thirty years.
By changing the refinance loan term to a 20-year loan (instead of a 30-year loan), the payment will rise to $1,247.84 per month, but the amount of interest paid over the life of the new 20-year refinance loan will drop to only $74,482.70 for an overall savings of $42,016.90.
Yes, a shorter term will mean a higher monthly payment. But in this example, using a 20-year loan instead of a 30-year loan saves so much more in interest charges.
Many borrowers who need additional funds may sometimes turn to refinances to obtain a higher loan amount. That new loan will first pay off the balance on the existing loan being refinanced. The remaining funds are then provided to the borrower.
Common examples of cash-out refinances include the following:
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