Benefits and drawbacks of refinancing a personal loan

Financial education, Loans

Illustration of a computer screen with someone reviewing the option to refinance vs. not refinance a loan.

Every personal loan has an interest rate, a repayment period, and a payment schedule. All these features are based on your application information, your financial situation at the time you applied for the loan and the lender’s product. If you’re unhappy with your current personal loan, you might be able to refinance it to get better rates or payments.

There are several reasons you might want to refinance a personal loan. You might need more money than the amount of your original loan. You might want lower loan payments, a better interest rate, or a different payment schedule.

However, refinancing also has drawbacks that you should be aware of. In this article, we’ll discuss both the advantages and disadvantages of refinancing a personal loan. This can help you make an informed decision about what is best for you.

Here’s what we’re going to cover:

  • What is personal loan refinancing?
  • Benefits of refinancing a personal loan
  • Drawbacks of refinancing a personal loan
  • When is it a good idea to refinance a personal loan?
  • When should you avoid refinancing a personal loan?
  • Oportun: Affordable personal loans for the hardworking people who need them most

Key takeaways

  • When you refinance a personal loan, you replace your existing loan with a new one. The balance of your existing loan will be paid off and you can use the rest of the money (if any) for whatever you need.
  •  This new loan comes with its own set of conditions based on your current financial situation.
  • The possible benefits of refinancing your personal loan may include a better interest rate, lower payments, or a shorter repayment term. Possible drawbacks may include extra fees, higher total interest, and a lower credit score.
  • When you refinance a personal loan for more money than your current loan, you keep the difference between the two amounts as cash. For example, if you have a loan of $500 and you refinance it with a $1,000 loan, then you keep the difference of $500, assuming there is no origination fee or similar cost.

What is personal loan refinancing?

Refinancing a personal loan means replacing your existing loan with a new one. You can apply for this new loan with your current lender or choose a different lender. Some lenders may not offer to refinance loans from other lenders, while others do not allow you to refinance for more than you owe on your current loan.

The new loan can either be for the balance remaining on your current loan or for more money. If you choose to refinance with a larger loan, you can pay off the balance on your current loan and still have money left.

People typically choose refinancing in order to get more money or better loan terms. Some of the features that may change with refinancing include:

  • Interest rate
  • Repayment term
  • Fees
  • Payment schedule
  • Payment amount

The new loan agreement you qualify for is based on your current financial situation among other factors. If your finances have improved, there’s a chance you’ll now qualify for better loan terms such as a lower interest rate.

Note: If you refinance and have a longer repayment term, you could end up paying more in interest over time.

Benefits of refinancing a personal loan

Refinancing a personal loan can offer several benefits. Remember that you may not be able to get all these advantages when you refinance. You’ll need to decide which benefits are the most important to you.

Lower interest rate

Your interest rate is the cost you will pay each year to borrow money expressed as a percentage rate. It does not reflect fees or other charges you may have to pay for the loan. If your interest rate is high, it means you’re paying more money for your loan.

The interest rate you are charged may be based on your credit score. If your credit score has increased since you applied for your current personal loan, you may now qualify for a lower interest rate.

What is a credit score?
Your credit score is a number between 300 and 850 that gives businesses an idea of how likely you are to make payments on time.

Lower payments

You may be able to decrease your loan payments by refinancing. Even if your interest rate stays the same, you could get lower payments by agreeing to a longer repayment term. This is the amount of time you have to pay back the loan. When your remaining debt is spread over a longer period of time, the individual loan payments become smaller. If you’re having trouble making your payments on time, this could be a good option for you. However, if you extend your repayment term, you will pay interest over a longer time period and you may pay more money.

Shorter repayment term

Owing money can be stressful. If you want to get out of debt as fast as possible, refinancing can allow you to get a loan with a shorter repayment term. With a shorter loan term, you may be able to pay off your loan faster if your refinanced loan gives you a lower interest rate and you don’t increase your loan amount. However, a shorter repayment term also means that your individual payments could be higher.

More money

When you refinance a loan, you might be able to get more money. Let’s say you have an existing loan for $500 but need to pay for a car repair. If you refinance to get a new loan for $1,000, this gives you $500 to pay off your current loan and another $500 to use for your expenses, assuming there are no origination or other fees.

Drawbacks of refinancing a personal loan

To find out what loan agreements you currently qualify for, you’ll need to do some research. If you don’t have time to shop around, or if your original loan is almost paid back, refinancing may not be a good choice for you.

Here are some of the possible drawbacks to refinancing.

Prepayment penalties

Prepayment penalties are fees you may owe for paying back your existing loan early. Some lenders charge prepayment penalties. Other lenders don’t. Review your loan agreement or give your current lender a call to see if prepayment penalties apply to your loan. If they do, you’ll be charged these fees if you refinance and pay off your current loan early.

Additional fees

Prepayment penalties aren’t the only fees involved in the refinancing process. Most lenders charge origination fees when they prepare a new loan for you. You may also have to pay new application fees, document fees, processing fees, and legal fees if you choose to refinance your loan. This could be costly, especially since you already paid these fees once, when you got your existing loan. If you refinance, you’ll be paying them a second time.

Higher costs

Refinancing can either increase or decrease your total costs. It all depends on your new loan agreement. For example, a longer repayment term may offer you smaller individual payments, but you could end up owing more money in interest. You’ll want to look carefully at all the options involved in refinancing before you make a decision.

Lower credit score

When you apply for a new loan, your lender will probably ask to see your credit report. This is called a hard inquiry. Each hard inquiry may cause your credit score to temporarily decrease. But don’t worry, hard inquiries typically only affect your credit score for one year. After two years, they are removed from your credit report entirely.

When is it a good idea to refinance a personal loan?

Here are some situations where you may want to refinance your personal loan.

Your credit score has increased

When you have a high credit score, your loan options are typically much better. If your credit score has gone up since you took out your current loan, you’ll be in a good position to get a lower interest rate.

Your loan payments are too high

Even if your credit score is the same, you may decide to refinance because you have a tighter budget than you did before. Maybe you recently lost some income or took on additional debt. Refinancing can help you get personal loan payments that fit into your new budget. When the individual loan payments are lower, you’re less likely to fall behind on making payments.

You want a lower interest rate

By refinancing your personal loan, you may be able to get a lower interest rate. In this case, you would pay less in interest and lower the total cost of the loan, if the repayment period stays the same and you make your payments on time. This could allow you to pay less money if the repayment term stays the same. To qualify for a lower interest rate, you’ll likely need a higher credit score than you had when you applied for your original loan.

You need more money

If you need more money, refinancing can be the perfect solution. Say you have a $500 loan but you refinance it for $1,000. By refinancing your loan, you can repay the original $500 and still have $500 left to use. You may also have to pay some additional fees, in which case your take home will be $500 minus fees.

When should you avoid refinancing a personal loan?

Refinancing a personal loan isn’t always a good choice. In some cases, you may end up paying much more in new fees and interest. Here are some situations where you should avoid refinancing.

Your credit score has decreased

Since the point of refinancing is to get better loan terms, it doesn’t make sense to refinance after your credit score has gone down. Most lenders won’t be willing to offer you a better loan than the one you already have.

You plan to apply for new credit soon

Because refinancing can temporarily decrease your credit score, you may want to avoid refinancing right before you apply for new credit.

The cost is greater than the benefit

Refinancing your personal loan comes with many costs. These may include new fees, prepayment penalties, and possibly higher interest. If these costs are greater than the savings you’ll get from a new loan agreement, it’s probably better to keep your current loan.

Oportun: Affordable personal loans for the hardworking people who need them most

Now that we’ve explained the advantages and disadvantages of refinancing a personal loan, you can decide whether it’s right for you.

Through Oportun, you can get an affordable personal loan with low interest rates, personalized repayment schedules, and affordable payments. If you’re one of our existing customers, you may be eligible to refinance your loan. We’ll work with you to help you achieve your refinancing goals.

Sources

Consumer Financial Protection Bureau.What is a prepayment penalty?

Consumer Financial Protection Bureau. What’s a credit inquiry?

The information in this site, including any third-party content and opinions, is for educational purposes only and should not be relied upon as legal, tax, or financial advice or to indicate the availability or suitability of any Oportun product or service to your unique circumstances. Contact your independent financial advisor for advice on your personal situation.

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