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04 Sep

Is Refinancing Your Loan A Good Alternative?

  • By Editorial Team


Introduction to refinancing

As the name itself implies, refinancing is a procedure of replacing an existing loan with a new one. People, generally, refinance their loan hoping to reduce their EMIs, reduce their interest rate and loan tenure, or change their loan program from an adjustable rate mortgage to a fixed-rate. A few even opt for refinancing to get a little more cash than they currently have for a purpose like home renovation or paying off other debts.

However, to be crystal clear, it is not the same as a second mortgage. The process and criteria for getting a refinancing approval is more or less same as your first mortgage. Refinancing has profited many while others felt they made the wrong choice by opting for it. So, the process acts differently in different cases and must be opted for after a thorough research.  

Reasons why people go for refinancing

  1. To manage their EMI - By the time a person decides to refinance, a certain part of debt is already paid, so the existing loan balance is smaller than the original loan amount. This makes the renewed EMIs easier on the pocket. As the income grows gradually and the monthly instalments get trimmed, an individual enjoys the financial cushion and can spend more on other monthly expenses.

  2. To take more time for repayment - With refinancing, the borrower restarts the loan timer and thus, lengthens the loan tenure. However one shouldn’t extend the tenure too much lured by the advantage of lower EMIs and rate of interest as then, they will end up paying more for the loan over the long term. However, some loans have to be repaid in a specific time frame and refinancing is the easy way out if you don’t have the funds available to settle the loan within the deadline.

  3. To switch to short-term loan - Borrowers go for refinancing to reduce the loan period as well. With an increased income, some may want to settle loans early but sometimes the existing lenders levy a huge charge on prepayment. In such cases, refinancing gives the choice to close it sooner provided you have the capacity to make larger payments.

  4. To change loan type -Refinancing provides the option of choosing a different type of loan from the existing one. One can simply go from a variable rate type to a fixed rate loan. This is usually done when people wish to make fixed payments every month. 

Benefits of refinancing

  1. Shorter loan period - For example your current loan is for 20 years, and you are now in a position to pay it in 10 years, refinancing will give you that option while your present lender might levy a hefty charge on prepayment. You can close your loan sooner and save money on interest via refinancing. 

  2. Reduced interest rates - Refinancing at a lower interest rate will reduce the financial burden on you.  The new lender offers a new loan rate that's reasonably lower than what the borrower is paying at the moment. The reduction in EMIs is not solely because of a longer tenure but also lower interest rate.  

  3. Debt consolidation - Refinancing is beneficial when an investor obtains a single loan at an interest rate that would be lower than the current average interest rate of all loans. In this case, a fresh loan has to apply at a lower rate that will pay off all existing debt leaving the total outstanding amount at a substantially lower interest rate. This consolidation will let you focus on a single debt and save you in the long run from heavy interest costs.

  4. Get cash out for expenses - In a cash-out refinancing, the applicant gets a larger loan approved than his existing loan. The borrower can now take home the difference between the two loans in cash. Basically, it is done by homeowners. They pay the loan but they also use the extra cash from refinancing to meet their expenses or to pay off high-interest credit card dues or student loans and bring down the financial burden.

Things to evaluate before opting for re-financing

  1. Cost of Refinancing - This drastically varies from lender to lender. In case of refinancing, you are replacing the original loan with the new one that requires you to pay closing costs again. It includes mortgage fees, application fees, loan originating fees, documentation fees, credit report fees, title search etc. Generally cost of refinancing is quite high when it comes to a larger loan amount.

  2. Your Credit score - Keep an eye on your credit score. A good credit score determines the creditworthiness of an individual. Your refinance options as well as interest rates depend on the credit score. Higher the credit score, the lower will be interest rate.

  3. Debt to Income Ratio - DTI is a personal finance measure to keep a record of individual’s debt payment to his or her income. It is one way lenders measure a person's ability to repay debts and manage his or her monthly payments.  An individual can calculate DTI by dividing total monthly debts including mortgage value by gross monthly income.

  4. Evaluate your monthly payment - Analyzing your monthly mortgage payments will help you in evaluating your options. If refinancing is done at a lower interest rate or longer tenure, then it means lower monthly payment, and this would give you more options to do other necessary things with that budget. 

Refinancing may or may not be the best solution for every applicant. It differs from case to case. One needs to do a calculation about the fees charged by the present lender for leaving the bond midway and the benefits earned from the new lender and see if the pros outweigh the cons. For example, there is no sense in refinancing a home loan if you are planning to move after a few years or when you've only a few years of payments left on your loan. Refinancing is a simple and straightforward financial move given that you have done your calculations right and taken into consideration the above-mentioned points.

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Did You Know

Credit Worthiness

Before offering a loan, the lender evaluates the borrower's possibility of defaulting, by measuring his or her credit worthiness. This assessment is based on the borrower's credit history, credit rating or score, employment/ business history, banking history, income to expense ratio, and others.

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