If you don't watch out when you refinance a personal loan, you might get burned.
Personal loans typically have interest costs that are higher than secured loans such as a Mortgage or Car loans. They also usually have costs that are lower than those for credit card holders who carry a balance month over month. This middle ground is a good relief valve for cases where you require a loan for unsecured debt such as when you consolidate debts into a single loan. Over time, however, it is important to review the costs of your personal loan, because it might make financial sense to refinance.
Refinancing a loan refers to the act of changing the terms of the original loan contract. In order for that to happen, both you and your financial institution need to endorse the change. The reasons you might pursue a refinancing include to reduce the interest rate you pay, change the term length of the loan, or to modify the amount you owe.
Before you make a change to your loan for the purpose of refinancing, you should consider when during the loan term it makes sense.
Refinancing for Rates
Interest rates on a loan are based on the current prime rate. The prime rate is the rate at which banks loan money to their preferred customers. The prime rate is typically 3% above what banks themselves must pay to obtain funds for the purpose of originating loans. The rate banks pay is called the Federal Funds Rate, and that rate is set by the governors of the Federal Reserve.
A preferred customer is one with a very good credit score, or someone who has a lot of investments or credit products with the bank (or both). Few people qualify for prime rates on personal loans, so it is very likely the personal loan you hold will have an interest rate that is higher than the prime rate.
The Federal Funds Rate and the prime rate fluctuate over time, due to changes in the overall economy. Supply and demand in large markets, such as the housing market, can influence the rate set by the federal reserve.
If you have not compared current rates to what you are paying now, you might be getting ripped off. When you take out a loan, the interest is typically fixed, which means that for the duration of the loan, the same interest rate will apply. However, if during the term of your loan the prime rate goes down, and along with it the rate you would qualify if you were taking the loan out today, you should look to refinance to take advantage of the lower rate.
Refinance for a Better Return
Even if refinancing does not yield a better rate of interest, there still may be reasons to refinance. One key reason is if the loan would allow you to earn more with the introduction of more short term cash. In this case, you would be refinancing the amount of the loan to increase its size. But if the money can be used to earn money sufficient to offset the costs of the loan, refinancing makes sense. After all, banks do this when they borrow money to loan to you.
Refinancing may also make sense if it yields a quality of life return. For example, if you refinance to add a new addition on your home, it may improve your appreciation and use of your home. Once the addition is complete, you may also enjoy an increase to the value of your property when it comes time to sell.
Refinance for Emergencies
If health issues surface during the term of your original loan, you may have no choice but to refinance. Funds used for healthcare are more or less not negotiable, so with no other option, you can use refinancing to get your hands on required funds.
Other emergencies may include an unexpected death during the time of your loan. If you are obligated to pay for funeral costs, you may find that they exceed what you can bear. In that case, refinancing might make sense.
Finally, if you lose your job, you may need to work with your bank on refinancing options. Losing your job is a very touchy situation, and taking on additional debt is typically a very bad idea. Unfortunately, your bills still need to be paid and you still need to eat. So in the case where you have no other option, refinancing may be an option you choose.
With any refinancing situation, you should be aware of the timeline remaining on your loan. Often banks will impose financial penalties on refinancing, which can include administrative fees or prepayment penalties of 3 months interest. Certainly if that is the case and you are within 3 months of paying off the loan, it does not make sense to refinance, even if rates are better today.
The other consideration with time, is that if you observe preferable rates, you need to act immediately. Banks will not back date rates to a point in history. When you make the decision to refinance ensure that any agreement you get with your financial institution is in writing, as verbal agreements won't cut it when it comes to apply the new rate.
Summary
So there you have it: three key considerations when thinking about when to refinance a personal loan. It makes sense to monitor the prime rate at all times and seek to refinance if it dips below the level it was at when you took out the loan originally. If you find yourself in a position where additional loan funds could provide liquidity to a situation where the amount you could earn would exceed that of the revised loan contract, you may also want to consider refinancing. And finally, there are cases where emergencies surface and you have no other choice.
But in all cases, it is important to identify if prepayment penalties or administrative fees would exceed the gain you would make by refinancing. If they would, you should hold off on refinancing until the loan term expires.
Do you have experience in refinancing a personal loan? What considerations did you include in your decision-making process?