Refinancing a personal loan is often an opportunity for a borrower to get a better interest rate or cover more financial needs. And yet, many people would ask what’s the catch? So, today we’re exploring all the pros and cons of refinancing a personal loan, as well as explaining when it makes sense to refinance and how to do it.
What does it mean to refinance a personal loan?
To begin with, let’s clarify what refinancing a loan exactly means. When you refinance an existing loan, you basically replace it with another loan. For this purpose, you take another loan either from the same lender or from a different financial service provider to pay off your debt.
At first glance, it may make no sense to pay the loan costs with newly borrowed money. Why then do so many people do that?
According to the latest 2023 statistics, 22.5 million Americans today owe a collective $222 billion in personal loans, which is twice as much as registered in 2016. More than half (55.7%) of borrowers seek personal loans to pay down existing debt: 38% do it for debt consolidation and 17.7% – for refinancing credit card debt.
The main reason customers are increasingly looking for refinance options is that it can potentially lower the total cost of the debt. In some cases, the reason is growing financial needs.
Personal loans often undergo refinancing, being a common type of borrowing which encompasses multiple purposes from enabling home renovations or paying for surgery to opting for a vacation of your dreams. Such loans can be offered by banks, credit unions, or online lenders.
As for the loan terms, they differ greatly depending on each individual case. Some of them require collateral while others come unsecured. Some personal loans have more favourable interest rates than others. Fees incurred, lending amounts, and repayment terms also vary.
Benefits of refinancing a personal loan
One of the most common purposes of refinancing is to get a better interest rate, thus bringing down the total amount of your personal loan.
How to get a better rate when refinancing your personal loan?
How does that work? One’s credit score is not a constant rock-solid estimate figure. It changes with time and may significantly improve since the time you got your existing loan in the first place.
Now, imagine that you have followed all the advice and your credit score has improved from bad to a good one. Bingo! You’re now able to obtain a more competitive interest rate as a result.
Sometimes, a general market situation might also be helpful to borrowers. As we know, economic conditions impact all types of interest rates. For instance, national regulators may manipulate the rates of interest in an effort to tame inflation or cope with other economic crises.
Let’s say, the interest rates were high overall when you got your initial loan, but now the market has stabilised and the rates are much more favourable. Why not use this chance and refinance at better terms?
Additional advantages of refinancing
Another possible advantage of refinancing a personal loan is extending your repayment term.
When the original loan is too limited in time and you realise you may not be able to pay it off in a timely manner, refinancing gives an opportunity to extend the repayment period.
Moreover, refinancing to a longer loan term offers lower minimum monthly payments. Therefore, it eases pressure on the household’s monthly budget, allowing them to tackle multiple debts, finance emergency expenditures without additional loans and also lower the mental stress of being in debt. People may lose their jobs or have reduced income for other reasons. In such cases, lower monthly loan payments come in handy.
In some cases, you may choose to refinance when you need more money for a new expense or financial need. Instead of having to handle a few smaller loan amounts that all come with different APRs and terms, a larger personal loan may allow you to consolidate your debt into one place, making it easier to track and manage.
Furthermore, some personal loans come with a balloon payment, forcing you to make an extra large payment towards the end of your repayment period. Refinancing is a way to avoid the balloon effect and change the loan type.
Switching your rate type as a result of refinancing a personal loan
As you know, interest rates that apply to personal loans may be of different types.
- Fixed interest rate remains unchanged throughout the whole lending period. No market changes or inflation will change it. It is advantageous when interest rates tend to increase. However, over the long term, the average rates might also go down significantly. In this case, the stability of a fixed interest rate will be unfavourable.
- Variable interest rate is flexible, meaning that it changes along with market trends. Customers often choose this type of interest rate, since variable interest loans may start with a lower annual percentage and offer higher credit. However, it is also risky. You never know how market tendencies will turn out, especially if you take out a long-term loan.
Having a variable APR on a personal loan makes it difficult to plan for your monthly payments. Besides, if you start noticing an upward trend that is not likely to end soon, you’ll end up paying off more. In such cases, refinancing gives you an opportunity to switch from a variable to a fixed rate so you can enjoy the stability of paying consistent payment amounts each month.
When is it unreasonable to refinance a personal loan?
Despite all the possible benefits of refinancing, the process doesn’t come without its cons. Therefore, there are a few significant factors to consider before refinancing a personal loan.
- Extending the repayment period with refinancing may lower your minimum monthly payments, but it will increase the total loan sum (principal + APR). Thus, all borrowers must clearly understand the implications of refinancing with an extended term, set their priorities and make sure it aligns with their expectations.
- Switching to a fixed rate with the help of refinancing is not always beneficial, as the market is unpredictable. Over the long term, the average rates might go down significantly. In this case, sticking to a fixed rate costs you more. So, refinancing a personal loan with a change in rate type is often akin to gambling or trading in terms of gains.
- Taking out a refinance loan may incur additional fees, e.g. origination fees or application fees. Additionally, you may face a prepayment fee with your existing loan if you pay it off before the repayment period ends. So, don’t forget to factor in all the fees before applying for a refinance loan. If your existing loan balance is minimal, refinancing might make no sense as the applicable fees might be as high as the perceived financial benefits.
- Looking to extend the repayment period, one might miss the fact that refinancing might not only decrease but also increase the interest rate (i.e. your credit score has worsened during the period). In such cases, you’d better think carefully about whether you should proceed and look for other ways to pay off the outstanding amount quicker.
Practical ways to refinance a personal loan
Carefully weighing all pros and cons, you might have already made an informed decision to refinance your existing personal loan. Here is how to do that in practice. To illustrate the process, we’ll take a look at one of the popular US lenders – Oportun – that offers unsecured and secured personal loans in 34 states around the country.
Can I get a second loan with Oportun?
This is one of the most frequent questions that the lender’s customers ask. Oportun offers small personal loans to borrowers with limited or no credit history, using a soft credit check that doesn’t significantly impact one’s credit score.
However, the company only allows borrowers to have one loan at a time. Therefore, refinancing an Oportun loan is by far the only chance to get more money from the same lender.
How to refinance an Oportun loan?
The process of refinancing a personal loan is very similar to a loan application.
- First, you should review your credit score and assess whether it has improved since you took your current loan. If it’s not improved, or worse – decreased, you’d better work on your credit score before you apply for refinancing.
- Compare existing offers to make sure you can get the best refinancing option. Consider all financial aspects, including fees, interest rates, repayment terms, etc. Shop around and don’t forget to check the availability because not all the lenders offer refinancing terms for third-party loans.
- Now, complete the application for personal loan refinancing. The commonly required documents are:
- A government-issued ID or your Social Security Number (SSN);
- Proof of address (a utility bill or an insurance statement with your home address);
- Proof of income;
- Contact information for your employer;
- A list of your regular monthly payments.
- If your refinancing application is approved, review the new loan agreement, finalise the loan and sign the contract.
- Check upon the ways your old loan will be paid off. Clarify the terms with the new lender to find out if they automatically pay it off for you, or you need to do it yourself.
- As everything is nice and clear, you’ll start making payments on your new loan, based on the new due date and minimum payment.
Refinancing a personal loan may help a borrower to get a better interest rate, cover more financial needs, extend their repayment term or alleviate the burden of monthly payments with minimal amounts required. However, replacing an existing loan with another one doesn’t always mean paying less money in the end, or even getting more favourable loan terms. So, you must consider every detail before taking out another financial responsibility.