In simple English, loan refinancing is when you take the terms of your current loan agreement and change them. The types of loans that this is done for are generally long term loans backed by securities (thing of value) such as your house or your car. There are two main reasons to refinance a loan, the first is to change your monthly payments, convert it to a fixed/adjustable rate mortgage to lock in rates, and to obtain built up equity in the security (generally your house).
Three Positive Reasons To Refinance
The first reason to refinance a loan is to lower your monthly payments. This is generally done by extending the length of the loan. Since you are paying the loan for longer you are making more payments, and thus each individual payment can be lower. It is also possible to refinance at a lower interest rate if interest rates have lowered since the beginning of the loan. As you are paying less in interest over the course of your loan, it is possible to lower either the length of the loan or each individual monthly payments. This is very common in mortgages and car loans.
The second reason to refinance a loan is to convert it from an adjustable rate loan to a fixed rate loan. This is very common with mortgages. Fixed rate loans usually have higher interest rate than adjustable rate loans. This is because they are riskier for banks. If the interest rates go up, then the bank makes less or even loses money on fixed rate loans. For that reason adjustable rate loans are more attractive for banks. A market for fixed rate loans exists because they provide more stability and security for borrows. So a middle ground is reached by which a fixed rate loan is available, but at a higher interest rate. It is also possible to refinance from a fixed rate loan to an adjustable rate loan and vice versa.
The third reason to refinance is to obtain equity that has built up in the security. For example, if you put $10,000 down on a house and over the past five years your equity has grown to $30,000, it is possible to refinance your mortgage to obtain that $20,000 that you have built up. A common use for this type of refinancing is to us the equity to pay off high interest debt such as credit card debt, or for investment purposes.
Three Possible Negatives To Refinancing
There are negative aspects of loan refinancing. Many times there are many fees associated with loan refinancing, called “closing costs”. For mortgages especially, refinancing generally involves a processing fees and penalties at your bank. The average mortgage processing fee in 2008 is on the order of $700, although it varies form bank to bank. Banks also commonly ask for a certain percentage of the loan to be paid upfront as a fee. The terminology used by the banks in this respect is “points”. Each “point” is one percent of the total amount refinanced. So refinancing a $100,000 loan at 2 points means the borrower must pay $2,000 as a refinancing cost.
A second negative consequence is that, just as in Vegas, the house always wins. Before refinancing, the bank already has a contract with you to make a certain amount of profit for them. They have no incentive to refinance unless a business case can be made to them that their profit will increase after refinancing. A pristine example of this is refinances a loan to a lower monthly payment but a longer length. This helps the borrower in the short term, but means that the bank will increase the amount of interest they collect over the long term.
The third consequence is the common strategy of using home equity to pay credit card debt. There are two main negative side effects to this. The first is that you have transferred unsecured credit card debt (if you cannot pay you do not lose your house) into secured debt (if you do cannot pay you DO lose your house). You are lowering your monthly payments, but increasing your long term risk. The second is the unintended side effect of having zero balances on your credit cards. Unless the borrower’s spending habits have changed then the debt cycle will begin again. For this reason some banks are offering financial and budgeting education to their home equity loan clients.
A Word ToThe Wise About Loan Refinancing
Always remember the old saying “Never ask an encyclopedia salesman if you need an encyclopedia.” Bank officers will offer you products that make sense for the bank to sell you. Just like other financial products such as mutual funds, bank officials have incentives to sell certain products with certain characteristics. Hopefully those characteristics intersect nicely with what you need. In the case of loan refinancing, remember it is the steak you are buying want, not the sizzle. Low or no closing cost refinancing generally have higher interest rates, and sometimes you have other options other than loan refinancing. Asking a loan refinancing officer if loan refinancing is your best option is not always the way to elicit the most unbiased advice. Get educated before you walk into the bank is the best way to choose the right refinancing option for you.
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