When and how to refinance a personal loan
Personal loans can be a helpful resource for eliminating high-interest debt. Such loans have various uses, with consolidating and paying off credit card debt being one of the top uses. While a powerful tool, personal loans aren’t static. If your financial situation has changed since receiving the initial funds, it’s possible to refinance the loan to get a better rate or change the terms. Before deciding to refinance a personal loan, it’s important to assess whether it makes financial sense by reviewing your current loan terms, payoff balance, and credit score. This guide shares how to refinance a personal loan, why you might want to consider it, and how it might save you money on interest.
Understanding personal loan refinancing
A personal loan refinance isn’t difficult to do, especially if your finances have improved since first taking the loan. Before starting the refinancing process, review your original loan agreement for any restrictions or prepayment penalties that could affect your options. By following several simple steps, you may be able to ease your financial burden.
What is personal loan refinancing?
Refinancing a personal loan is a straightforward process where you replace your original personal loan with a refinance loan that may offer better terms, such as a lower interest rate or reduced monthly payments. In essence, you use the new loan to pay off your current loan in full.
For example, if you have a loan balance of $10,000 with a 12% APR, with a monthly payment of $222, refinancing it to a 7% loan would reduce it to a $198 payment, or a monthly savings of $24. That would save $1,440 over a five-year loan.
Refinancing is typically only advisable when rates are lower, allowing you to reduce monthly payments. With personal loan originations increasing 23% year over year, according to TransUnion, more Americans may want to consider refinancing if rates drop.
How personal loan refinancing works
Refinancing an unsecured personal loan is not difficult, but following certain steps is necessary. Here’s what you need to do to refinance a loan.
- Decide what you need: Paying off the initial loan is the traditional goal of refinancing. Determine what’s necessary to do that. Some lenders may charge a prepayment penalty, or you may incur an origination fee with the new lender. Both can impact the amount. Do the math to learn what it will take to pay off the loan.
- Review your credit: It’s often wisest to only consider refinancing when your credit score improves. If you’ve made an effort to pay bills on time and avoid using too much credit, your score may have improved. Many credit card companies and banks let you access your credit score for free. Assuming your credit is improving, it’s fine to move on to the next step.
- Comparison shop loans: Interest rates vary by lender, so it’s best to comparison shop within a short window, often 14 days, to find the best loan terms and interest rate. Compare rates and loan offers from several lenders, including banks, credit unions, and online lenders, to find the best personal loan offers. Many lenders allow you to prequalify without a hard credit pull, making it easier to compare rates and terms from multiple lenders. It’s prudent to review all lenders you’re seriously considering before making a decision. “I recommend reviewing the lender you plan to refinance with for legitimacy, especially with offers that may sound too good to be true. Never let a lender pressure you into making a quick decision, especially if they seem wishy-washy about the fine print of your new loan terms,” says Leslie H. Tayne, Esq., finance and debt expert and founder of Tayne Law Group.
- Submit your application: Once you decide on a lender, submit it. Lenders often request documents such as pay stubs or tax returns. You will also need to provide your Social Security number. Most lenders process applications within several business days.
- Pay off the first loan and make payments on the second: Your new lender may either pay off your initial loan directly by sending the loan funds or loan proceeds to your existing lender or current lender, or they may deposit the funds into your checking account or bank account. If the funds are deposited into your account, use them to pay off the first loan in full. Establish autopayments on the new loan and confirm the first loan is closed out.
When to consider refinancing your personal loan
It may be challenging to know when to refinance a personal loan. Lenders will consider your debt-to-income ratio, payment history, and credit history when evaluating your refinancing application. Situations vary, but here are some common times when it may be wise to consider refinancing an unsecured personal loan.
Improved credit score
Credit scoring isn’t a perfect system, but an improving score can unlock lower interest rates. For example, if you’ve actively reduced your credit utilization ratio, your credit score may increase to 720 or above. Borrowers with excellent credit are more likely to qualify for the lowest interest rates and the most favorable loan terms when refinancing. This may allow you to qualify for lower rates, helping you save money on interest. However, if your credit score is under 670, you may see minimal change in rates.
Change in financial situation
Have your overall personal finances improved recently? Perhaps you have a new, higher-paying job, or you’ve paid off remaining debts. You may be a good candidate for a personal loan refinance.
Refinancing can also help improve your monthly cash flow by reducing your payments or consolidating debt, making it easier to manage your finances.
You want to pay off the loan faster
Reducing rates, generally speaking, allows many people to shed debt sooner. By refinancing to secure lower loan rates, you can decrease your interest costs and potentially pay off your debt faster. Assuming you don’t incur a prepayment penalty or origination fees, refinancing may allow you to reduce the loan term and become debt-free more quickly.
You need lower payments
People don’t always want to pay off their personal loans faster. Circumstances may have changed, leading them to want to extend payment terms. Refinancing may allow for that, helping you achieve a lower monthly payment and more manageable monthly payments by opting for a longer repayment period. This adjustment directly affects your monthly payment amount, making it easier to fit payments into your budget. Be aware, though, that not all lenders may allow that.
“Not all lenders allow extension of terms, especially when current on payment,” notes Tayne. “If a consumer is feeling underwater with their monthly expenses, then having a conversation with the lender about options is the first step. Longer repayment terms may require going through the underwriting process, and the lender may decline, especially if the borrower can’t show proof of ability to pay.” Worse yet, extending loan terms may result in higher interest rates or fees.
Benefits of refinancing a personal loan
There are various benefits to refinancing your personal loan. For example, you may be able to borrow more money to cover new financial needs or consolidate existing debts. These are several of the top perks of a personal loan refinance.
Lower monthly payments
Monthly payments can be a drag on a budget, making it challenging to achieve financial goals. Refinancing a personal loan can lower your monthly payments, allowing you to allocate the savings to other needs. When you refinance, you can calculate and compare your new monthly payment to ensure it fits your budget.
Let’s say you have five years remaining on an initial seven-year loan of $25,000 with an APR of 12% vs. a new five-year loan with a 6% APR; Your current payment would be $556, compared to a new payment of $483, resulting in a monthly savings of $73. You would realize a savings of $4,400 over the five years, assuming no fees.
Reduced interest rates
Many personal loans have fixed interest rates, but that’s not always the case. If you have a variable-rate loan, you may benefit from refinancing into a fixed-rate loan. Doing so may result in lower interest rates.
Moreover, if your credit score is improving, you may qualify for lower interest rates, helping you save in the long run.
Debt consolidation opportunities
Refinancing a loan may provide you with debt consolidation opportunities. If you have two loans you want to consolidate into one, or you have outstanding credit card debt, you may want to consolidate them into one loan. Refinancing can help you pay off existing debt by replacing it with a new loan, which can simplify payments and potentially lower your interest rate.
Tayne warns it’s not always beneficial, though. “Be cautious when refinancing a personal loan, as lower monthly payments or debt consolidation can lead to higher interest paid over time, potentially costing you more in the long run,” she says. Doing the math is essential before refinancing.
Potential drawbacks to consider
Refinancing doesn’t always work out for everyone. There are some personal loan refinancing disadvantages to keep in mind, and in some cases, it may be best to avoid refinancing, such as when interest rates have increased, your credit score has declined, or when fees like origination charges outweigh the potential savings. Consider these drawbacks before agreeing to a loan.
Fees and closing costs
Fees and penalties are an unfortunate reality with many personal loans. Prepayment penalties, origination fees, and other additional costs are common with unsecured personal loans. Many lenders charge origination fees as a percentage of the loan amount, which are deducted from the loan proceeds; it’s crucial to factor these fees into your loan comparison. Carefully review all loan documentation to understand the full cost, as Tayne points out that important loan terms and potential fees may be hidden within the fine print.
“It’s important to review your new loan term agreements thoroughly and in full before signing the dotted line. Loan agreements may have hidden fees, or may seem favorable, but important information about payments increases after a period of time could be buried within the documents,” she says.
Impact on credit score
Applying for a new personal loan typically involves a hard credit pull, which is a hard inquiry on your credit report and can temporarily lower your credit score. The hit is usually temporary, but it’s something to take into consideration. To help minimize impact, it’s best to rate shop within a two-week period.
Extended debt timeline
Refinancing to a longer term can reduce payments, making them easier to manage. However, that’s not always a good thing. An extension can keep you in debt for longer and may ultimately cost you more in the long term.
“With that extending terms may come with higher interest and other cost penalties which may end up costing the consumer more in the long run, so short term savings may result in higher overall costs, but would likely be a better option than defaulting on the loan,” notes Tayne.
Frequently asked questions about personal loan refinancing
It’s common to have concerns when asking yourself ‘Can I refinance a personal loan?’ These are typical questions people have when considering personal loan refinancing.
Yes, it’s possible to refinance many personal loans. Each lender manages refinancing differently, but if your credit score has improved and you have a stable income, you can be a candidate for refinancing. Just be aware that you may incur some fees for the procedure.
There is no set timetable for refinancing a personal loan. Generally, if your loan is in good standing, you can request to refinance once payments begin. Requirements vary by lender, and you may face fees or penalties that can erode savings.
It is possible that you will see a temporary, albeit minimal, hit to your credit score. Any impact should erode relatively quickly, especially if you make consistently on-time payments.
It’s not uncommon to face a prepayment penalty if you pay off a personal loan early. However, fees vary by lender. It’s best to do the math to determine if you will save money in the long run.
Bottom line
Refinancing a personal loan can be a good way to reduce interest rates and eliminate indebtedness faster. It’s not a one-size-fits-all approach, though.
“Refinancing a personal loan can have worthwhile financial benefits so long as it makes sense in the overall financial plan, but it’s important to weigh the pros and cons related to credit score, costs, and exposure to debt before making your decision,” Tayne adds. If your credit score and financial standing have improved, pursuing a refinance can further strengthen your finances, but if not, continuing to make payments on your original loan may be better.
