What Refinancing Actually Means
Refinancing means replacing an existing loan with a new one, usually to get a lower interest rate, a different repayment term, or both. The new loan pays off the old one, and you start making payments on the new terms. It is most commonly associated with mortgages, but you can refinance auto loans, student loans, and personal loans as well.
Refinancing is not free. There are typically closing costs, origination fees, or other charges depending on the type of loan. For a mortgage refinance, closing costs often run 2-5% of the loan amount. For student loans and auto loans, fees are usually lower or nonexistent, but the terms of the new loan still need to be evaluated carefully.
The Break-Even Calculation
The most straightforward way to evaluate a refinance is the break-even point. Take the total cost of refinancing and divide it by the monthly savings. If refinancing your mortgage costs $4,000 in closing costs and saves you $200 per month, the break-even point is 20 months. If you plan to stay in the home longer than 20 months, the refinance saves money over time. If you might move sooner, the upfront cost may not be recovered.
This calculation gets more nuanced when you factor in the loan term. Refinancing a 30-year mortgage into a new 30-year mortgage resets the clock. You might lower your monthly payment but end up paying more in total interest over the life of the loan because you extended the timeline. Refinancing into a shorter term (like a 15-year) increases the monthly payment but dramatically reduces total interest paid.
Student Loan Refinancing -- Special Considerations
Federal student loans come with protections that private loans do not -- income-driven repayment plans, deferment and forbearance options, and potential forgiveness programs (such as Public Service Loan Forgiveness). When you refinance federal student loans with a private lender, you permanently give up access to those federal protections. The lower interest rate may or may not offset that loss, depending on your individual circumstances and career plans.
Refinancing private student loans with another private lender does not carry the same tradeoff, since private loans do not have those federal protections to begin with.
This content is for general educational purposes only and does not constitute financial advice. Loan terms and eligibility vary. Consider consulting with a qualified financial professional before refinancing any loan.