Refinancing

Refinancing is a new loan wearing the old loan's purpose. A new lender, or the same one, lends you the amount still owed, uses it to pay the old balance off, and from then on you owe the new lender at the new rate and on the new term. The saving is the gap between the two payments and the cost is the closing costs, so a refinance pays off only if you keep the new loan past the month those costs are earned back. That break-even month is the number every refinance decision turns on.

In a sentence

• "Refinancing from 7.0% to 6.0% cut the payment by $247 a month, so the $6,000 in closing costs is earned back in about two years."
• "She is refinancing the car loan through the credit union because the dealer's rate was two points higher."
• "Refinancing replaces the loan with a new one; a loan modification changes the terms of the loan you already have."

How it works

1. Apply for the new loan as you would for any loan. The lender checks your credit and income, and for a mortgage orders an appraisal, because the new loan is secured by the home's current value.
2. Choose the rate and the term. The term restarts unless you choose a shorter one, so a mortgage with 27 years left becomes a 30-year loan again by default.
3. Pay the closing costs, in cash at closing or rolled into the new balance, which raises the balance and the payment a little.
4. The new loan pays off the old one. The old lender reports the loan closed, and the new lender sends the first statement.
5. Keep the new loan past its break-even month, or the costs outrun the saving.

Break-even months = closing costs ÷ monthly saving

A federal student loan refinanced with a private lender becomes a private loan, and the repayment options that came with the federal loan do not carry over.

An example

A household owes $280,000 on a mortgage at 7.0% with 27 years left, and a lender offers 6.0% with $6,000 in closing costs, paid in cash. Both rates are the example's inputs.

The new 30-year loan has the lowest payment and a break-even of about two years, but $68 of its $247 saving comes from stretching 27 years of payments into 30 rather than from the lower rate, and it pays about $38,000 more interest than the loan that ends on the old date. Keeping the old $1,926 payment on the new 6.0% loan clears it in 261 months, just under 22 years, with $221,233 in interest, about $122,750 less than staying put. The $6,000 sits on top of every refinance figure in the table.

Why it matters

A refinance is the one way to change the price of a debt you already have, and on a mortgage a single percentage point is worth tens of thousands of dollars over the term. The mistake it invites is reading the payment drop as the saving. A lower payment on a longer term can cost more in total, closing costs rolled into the balance are borrowed at interest for decades, and a household that sells or refinances again before the break-even month has paid the costs for nothing. The decision turns on the monthly saving at the same remaining term, the closing costs, and how long you expect to keep the loan.

Refinancing versus a loan modification and a balance transfer

A refinance is a new loan; a loan modification is the same loan with changed terms. A lender modifies a loan for a borrower who cannot make the payments, lowering the rate, extending the term or adding missed payments to the balance, with no new application and no closing costs; it is offered in hardship rather than shopped for. A balance transfer is the credit card version of a refinance: the balance moves to a card with a lower or promotional rate, for a transfer fee instead of closing costs, and the promotional rate expires. The arithmetic is the same in each case, the cost of the move against the interest it saves over the time you keep the debt.

Common questions

Is refinancing the same as debt consolidation? No, though the two overlap. Refinancing replaces one loan with a new one on better terms. Debt consolidation replaces several debts with a single new loan, which is a refinance of all of them at once, chosen for the single payment as much as for the rate.

When is refinancing worth it? When the monthly saving, measured against a loan with the same end date, repays the closing costs well before you expect to sell or refinance again. A break-even of two years on a loan you will keep for ten is a clear yes; a break-even of four years on a home you may leave in three is a no, whatever the rate.

Does refinancing hurt your credit score? A little, for a short time. The application adds a hard inquiry, the new loan is a new account, and the old one closes; scores commonly dip by a few points and recover within months of on-time payments.

Does refinancing reset the loan? By default, yes. A new 30-year mortgage starts its 30 years on the day it closes, and the early payments are mostly interest again. Choosing a term that matches the years left on the old loan, or paying the old payment on the new loan, keeps the payoff date where it was.

Go deeper

• The Mortgage calculator estimates the full monthly payment on a home at the new rate and term, principal and interest plus property tax, insurance, HOA dues and PMI, and the total interest over the life of the loan.
• The Loan calculator estimates the monthly payment on a car, personal or student loan at the rate you are offered, the total interest over its life, and how much sooner it ends if you pay a little extra each month.
• How paying off debt raises your net worth shows why the principal in every payment, and not the payment itself, is what a lower rate buys you more of.