When and how to refinance a personal loan

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Taking out a personal loan to consolidate debt or pay for a major expense can go a long way in helping with your finances. However, once you’ve begun making payments on the loan, you may start to realize that refinancing is a good option. Refinancing your personal loan makes sense if your credit score has improved to a level where you may be offered a rate reduction or if you need a longer term in order to lower your monthly payments.

Get pre-qualified

Answer a few questions to see which personal loans you pre-qualify for. The process is quick and easy, and it will not impact your credit score.

What does it mean to refinance a personal loan

When you refinance a personal loan, you’re using an entirely new loan to pay off the existing loan. There are many different reasons why one might want to do this, but ideally you’ll obtain a new, better interest rate as part of the process.

“Usually the goal is reducing your payment or lowering your interest rate. The new loan may also be for a greater amount if the goal is to get more money for a new need,” says Vida Awumey, vice president and director of policy research for OneMain Financial.

When does refinancing a personal loan make sense?

Refinancing your loan almost always makes sense if it will save you money. There are many scenarios under which it may be possible to achieve substantial savings.

“For example, if interest rates drop and you are able to get a lower interest rate, you would want to consider refinancing,” says Adam Marlowe, principal market development officer for Georgia’s Own Credit Union.

Here are some other times when it may make sense:

  • You have a better credit score. One of the best ways to qualify for a lower interest rate on your personal loan is by improving your credit score. If your score has seen a jump since you initially took out your loan, this could be a good reason to refinance.
  • You want to switch your rate type. Having a variable APR on a personal loan makes it difficult to plan for your monthly payments. Not only that, you might see an upward trend that ends up costing you more. By refinancing, you can switch from a variable to a fixed rate so you can enjoy consistent payment amounts each month.
  • You want to avoid a balloon payment. Some personal loans may come with a balloon payment, requiring you to make a much larger payment than the normal monthly amount at the end of your repayment period. You can refinance ahead of time to avoid this style of personal loan.
  • Your income decreased and you need lower monthly payments. If you’ve lost your job or have reduced income, you may be looking to lower your monthly loan payment. In this case, you may want to refinance your current loan for a longer repayment term, which may not save you money in the long run but could help reduce the monthly payment.

How to refinance a personal loan

If you are ready to refinance your loan, start with the following steps.

1. Figure out how much money you need

When you refinance a loan, you’re essentially paying off the existing loan with a new one that has different terms. So, before you shop for quotes, determine the exact amount of money required to pay off your current loan. You can get that information by logging into your account or directly calling your lender. Also ask if there are any prepayment penalties that might outweigh the benefits of refinancing.

2. Check your credit score and report

Before you consider refinancing your loan, you’ll need to know whether you qualify for a lower rate than what you’re currently paying. If the new interest rate isn’t significantly lower, it may not be worth it to refinance.

“Most lenders will quote their best rate, but if you don’t have A-plus credit, that may not be the rate you qualify for,” says Marlowe. “To get your credit score, check to see if your credit card issuer or financial institution provides this for free to their customers.”

You can also request a free credit report annually from each of the three credit bureaus — Equifax, Experian and TransUnion.

As you’re shopping around for a new loan, determine whether lenders do a soft pull or hard pull of your credit score when giving you a quote. A hard credit score will negatively affect your score, at least in the short term.

“Be sure to not allow lending institutions to pull your credit score until you are ready to decide on a loan and a lender,” says Jeff Wood, CPA and partner at Lift Financial. If a lender offers prequalification, you’ll be able to check your rate without formally applying, and the lender will do only a soft credit check.

3. Shop for rates and terms at banks and online lenders

Research is key in refinancing personal loans; before refinancing, compare rates and terms from multiple lenders. A new loan with a lower interest rate isn’t necessarily better if you’re paying more for it overall in fees or by extending it unnecessarily.

“Refinancing a loan may cost additional fees and will change the terms of the loan,” says Wood. “Your current loan may have a prepayment penalty in order to replace it. All of these factors must be considered to determine if a refinance makes sense, both personally and financially.”

If you’re not looking for lower monthly payments, it may also be unwise to extend the maturity of your new loan past the maturity of the current loan. Even if you get a lower interest rate, you could end up paying more in interest over a longer time frame. To compare the overall costs of your loans, try using a personal loan calculator.

4. Speak with your current lender

Don’t overlook your current lender during the research process. It may be willing to work with you and offer you a better deal than your existing loan.

“You already have an established relationship with that company,” says Awumey. “Your lender will assess your needs and determine your eligibility for a new loan. Many lenders will let you see if you are pre-qualified for a loan without making a credit inquiry.”

5. Apply for the loan

When you’ve settled on a lender whose offer you like best, submit your application and provide any required verification — this could include your Social Security number, paystubs, bank statements or tax documents. Also be sure to read through the fine print of the loan before accepting, taking note of your payment schedule and any fees, including prepayment penalties.

If you’re satisfied with the terms of the loan, you can accept it and typically receive funds within a few days. You’ll use these funds to pay off your current loan, then enter the repayment period of your new loan.

How refinancing a personal loan affects your credit score

When you refinance, you’ll be subject to a credit check. This can lower your credit score slightly, but the drop should be temporary — especially if you practice good financial habits with your new loan.

“Typically, a lender will need to check your credit. The refinanced loan will be a new loan account, and the previous loan will be paid off,” says Awumey. “Credit inquiries and new accounts can negatively affect your credit score in the short term, but making on-time payments on a new loan will help your credit score over the long term.”

Keep in mind that a small hit could hurt if you’re also looking to buy a new car or move into a new apartment. Car dealers and landlords check your credit score, and refinancing your loan at the wrong time could make it more difficult to find a vehicle or housing.

Advantages of refinancing a personal loan

While the specific advantages of refinancing your personal loan will depend on your goals, in general they can include everything from taking advantage of a lower interest rate to reducing the overall cost of your loan.

  • Better interest rate: If rates have dropped or you have taken steps to improve your credit score, you could be able to save money on interest.
  • Faster loan payoff: If you’re comfortable making higher monthly payments and you want to get out of debt faster, you can refinance a personal loan to a shorter term. This has the added benefit of reducing the amount of interest you’ll pay overall.
  • Extended repayment periods: Extending your loan repayment can help your payments feel more manageable if you’re having difficulty making them on time, since lengthening the terms will reduce your monthly bill.
  • Payment stability: Refinancing can provide payment stability if you’re switching from a variable rate to a fixed rate.

Disadvantages of refinancing a personal loan

Refinancing is not the best option for everyone. Before committing to a refinance, consider the following drawbacks:

  • Extra fees: Anytime you take out a new loan, you might have to pay additional lender fees, which can cut into the money-saving benefits you may be trying to achieve.
  • Prepayment penalties: Some loans come with a prepayment penalty when you pay off the balance before the term ends. Since refinancing requires that you pay off the existing loan and replace it with another, it’s best to check the terms of your current loan to determine whether or not you’ll be penalized for paying it off early.
  • Potentially higher interest costs: Extending a loan period usually results in more interest costs over time. If you’re trying to lower your monthly payment because of financial difficulties, you might still consider refinancing. Just understand that the lower monthly payment likely won’t save you money in the long run.
  • Credit score impacts: Because refinancing counts as a new loan inquiry, it can lower your credit score, even if the impact is minimal and temporary.
  • Research and application time: It takes time to research lenders, compare quotes and send in applications. If your loan is close to being paid off, refinancing may not be worth the hassle.

Get pre-qualified

Answer a few questions to see which personal loans you pre-qualify for. The process is quick and easy, and it will not impact your credit score.

The bottom line

If you’re looking to refinance a personal loan, it’s important to do thorough research: Will you get a lower interest rate? A lower monthly payment? Better terms? Once you’ve compared the pros and cons and shopped around with multiple lenders, you can determine whether refinancing makes sense.

Featured image by Noel Hendrickson of Getty Images.

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