Things to know when you refinance a personal loan

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In a Nutshell

If you’ve borrowed money at a high interest rate, you may be wondering if you should refinance your personal loan to get a lower interest rate or reduce the number of monthly payments. Here are some things to know about refinancing a personal loan.

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Who doesn’t like to save money?

In fact, saving money by refinancing high-interest debt into lower-interest debt could be the reason you wanted a personal loan in the first place. That’s one of the main reasons people seek personal loans, according to a Credit Karma study.

But what if you’d like to get a lower interest rate for an existing personal loan — and potentially save money — or decrease the number or amount of your monthly payments? Does it make sense to refinance your personal loan?

In some situations, refinancing a personal loan might make sense for you. But you should first examine the pros and cons of refinancing. Those include whether you’ll actually end up saving money by refinancing the loan and how your credit can play into the decision. You also need to consider the suggested steps for getting the lowest interest rate and lowest fees available for you.

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Advantages of refinancing a personal loan

When you refinance a personal loan, you’re replacing the existing loan with a new one. The funds from the new loan are used to pay off the old one. Refinancing a personal loan offers several potential advantages:

  • The opportunity to get a lower interest rate than what you’re paying on your current loan. If your credit has improved since you first took out your personal loan, you may be able to qualify for a better rate on a new loan. A lower interest rate could save you money on the overall cost of the loan.
  • Decreasing the dollar amount of your monthly payments by stretching out the length of the loan. For example, if you’re struggling to make payments with a loan term of 36 months, refinancing into 48 months could reduce your monthly payment. Keep in mind that extending the term of the loan can also mean paying more interest in the long run.
  • Cutting the number of payments by switching from a longer repayment period (like 36 months) to a shorter repayment period (like 24 months). If your financial situation has changed and you can afford to pay more per month to pay off your loan faster, shortening the loan term could help you get rid of the debt sooner.

Disadvantages of refinancing a personal loan

Before deciding to refinance your personal loan, it pays to consider the potential pitfalls of refinance.

Interest rate

If you’re refinancing for a longer loan term, one of those potential disadvantages is paying more interest, even with a more attractive interest rate. A longer loan term means you’re paying interest for longer, too. Your lower monthly payments could come with a higher total interest price tag over the life of the loan.

Online lender Marcus by Goldman Sachs® offers an example involving a $10,000 personal loan with a 15% interest rate and 36-month term versus a $10,000 personal loan with a 13% interest rate and 60-month term:

  • The 36-month/15% loan adds up to a monthly payment of $346.65, with total interest at $2,479.52 over the life of the loan.
  • The 60-month/13% loan offers a lower monthly payment of $227.53. Yet the total interest over the life of the 60-month/13% loan comes out to $3,651.84 — because the borrower will be paying interest for a longer amount of time.

While the 13% loan provides a longer term and lower payment, it also bumps up the total interest paid by $1,172.32.

What is the average interest rate on a personal loan?

Fees

Some personal loans hit you with extra costs, such as origination fees or prepayment penalties. If you face both, it would mean you have to pay a fee to end the old loan and more to begin the new one.

Even if your new loan has a much lower interest rate than the one you’re refinancing, origination fees could mean paying more over the entire loan term. So when you’re comparing terms between your existing personal loan and a new one, be sure to consider any origination fees and prepayment penalties, along with any additional fees and APRs.

Steps for refinancing a personal loan

Let’s look at the typical steps you’ll take to refinance a personal loan:

1. Shop around

Just like when you’re looking for a credit card or a mortgage, you should shop around when seeking to refinance a personal loan. This way, you can help ensure you’re getting the lowest interest rate you can qualify for, along with the most-favorable payoff period and manageable monthly payments.

Tip: Be sure to ask the lender that handles your existing personal loan whether it could refinance the loan. Or consider shopping for personal loans online through websites like Credit Karma.

2. Research the reputation of lenders

In 2017, the Consumer Financial Protection Bureau received 4,160 consumer complaints related to installment loans. Some of those consumers reported being told conflicting information about documents and other application requirements. Meanwhile, other consumers complained about being hit with interest charges or fees that they hadn’t expected.

To help avoid being surprised by fees or terms, do some digging. With a little research online, you can find reviews from the Better Business Bureau and other sources that might help you consider which lenders you want to do business with.

3. Check your credit scores

Before you decide on the right offer to refinance your loan, check your credit scores so that you know where you stand. Typically, people with higher credit scores are more likely to qualify for lower interest rates. And lower credit scores generally equate to higher interest rates.

Interest rates on personal loans can vary widely. A July 2018 search of personal loans for refinancing offered on Credit Karma showed interest rates ranging from 5.99% to 35.99%. One lender, Best Egg®, stated that FICO® credit scores of at least 700 and minimum individual income of $100,000 a year was required to qualify its lowest interest rate (5.99%) for a personal loan.

Prosper®, another provider of personal loans, explains that the interest rate it charges a customer depends on factors like credit scores and credit history, as well as the loan amount, loan repayment period and a host of other factors.

What is a good credit score?

4. Figure out the fees

An online loan calculator (or your own calculator) can help you determine how extra costs like origination fees and prepayment penalties can affect the cost of repaying the refinanced loan.

As we mentioned earlier, these fees can increase the total cost of a loan so that even a refinanced loan with a lower interest rate might mean you end up paying more to borrow money in the long run.

5. Consider prequalification for a personal loan

Prequalifying — a less formal assessment of your creditworthiness — doesn’t guarantee you’ll get a personal loan to refinance your existing one. But it could help you get an idea of your ability to qualify for a loan before you go through an application — and before you ding your credit with a hard inquiry on your credit reports. It can also help you understand if you’ll be able to borrow enough to pay off your existing loan and what interest rate you might get.

6. Fill out the application

Once you’ve shopped around, done the math and prequalified, it’s time to apply for refinancing.

Here’s where your research and prequalifications can pay off. When you apply for credit, the lender will typically check your credit reports, which results in a hard inquiry. Multiple hard inquiries in a short period could give lenders the impression that you’re a higher credit risk, so be careful about how many lenders you apply to.

Keep in mind, though, that the impact of a hard inquiry on your credit shrink over time.

How can refinancing affect my credit history?

Since refinancing means you’re getting rid of an old loan and taking on a new one, your credit might get dinged.

How?

Some credit-scoring models will consider the old loan when determining the average age of your accounts. But other credit-scoring models won’t include the closed loan when figuring the average age of your accounts — meaning the average age could go down.

Why is all of this important? FICO, a provider of credit-scoring models, says the length of your credit history represents 15% of FICO® credit scores.

But don’t overlook a potential upside of refinancing: If refinancing your personal loan makes it easier for you to make your monthly payments, and ultimately pay off the loan, those actions can positively affect your credit over the long term. Payment history accounts for about 35% of your FICO® scores, and the amount you owe on credit accounts determines 30%.


Bottom line

If you’ve got a personal loan and you’re weighing whether to refinance it, be sure to compare the pros and cons, including interest rate and any fees or penalties associated with ending one loan and opening another.

In the end, this comparison should help you figure out whether refinancing will save money, decrease your monthly payments or both. If you’ve determined that refinancing will benefit you, then make sure you check your credit scores, study the interest rate and fees for the new loan, and think about how refinancing can affect your credit.