Refinancing
Refinancing is replacing an existing loan with a new one, usually for a lower rate, a different term or a smaller payment. The new loan pays off the old balance.
A refinance is two transactions that settle together. The new lender advances enough to clear the outstanding balance on the old loan, that loan closes, and the borrower is left owing the new one on its own rate, term and schedule. Mortgages, auto loans, student loans and business debt are all commonly refinanced, and the borrower's credit profile at the time of the new application is what prices it.
Three things can change and they do not have to move together, and the loan payment calculator will show what any combination of them does to the payment and to the total repaid.
- A lower rate cuts the interest charged in each period.
- A longer term cuts the monthly payment and adds periods.
- A cash-out refinance sets the new balance above what was owed and pays the difference to the borrower.
Judging a refinance on the monthly payment alone is the error worth avoiding. Spreading a remaining balance over a fresh full term lowers the payment and can still increase total interest, because the balance stays outstanding for longer. A refinance also restarts amortisation at its interest-heavy beginning, and any origination fee, closing costs and penalty for clearing the old loan early have to be earned back before the lower rate is worth anything. The number that settles it is how many months of saving it takes to cover those upfront costs.