Rebecca Goodman
Rhiannon Philps
Refinancing a loan is when you use a new loan to pay off an existing loan.
It is similar to debt consolidation, but you’re only using the money to settle one loan instead of multiple loans.
When it’s done right, refinancing a loan could save you money on interest and cut your monthly payments. However, it may not always be the best option.
Find out how refinancing a loan works and whether it could be a useful option for you.
What is refinancing?
Refinancing a loan involves using a new loan to clear your old loan. The new loan will typically have a lower interest rate or a shorter term than your old loan.
Future repayments go towards paying off the new loan and the idea is that by shortening the term or switching to a lower interest rate you cut the cost of repaying the debt.
A shorter loan term may mean your repayments increase. But it will be settled sooner and you will pay less in interest overall than if you borrowed over a longer period.
How to refinance a personal loan
When you use a personal loan to refinance a loan, these are the typical steps you’ll need to follow.
- Ask your existing lender for a settlement figure to pay off your loan early. This figure is the amount you need to pay to clear your debt and will include any early repayment charges that may apply. It will usually be valid for 28 days.
- Shop around to see if you can find a new personal loan with a lower interest rate than your existing loan. You can use an eligibility checker, either from a direct lender or a broker that looks at multiple lenders, to see what loans you can apply for and at what rates. This will give you an idea of the costs without impacting your credit score.
- If you find a suitable loan that you’re likely to be approved for, you can apply. Bear in mind that this will involve a credit check that will appear on your credit file.
- Once you have the money, you can pay off your previous loan. Contact your lender if you’re not sure how to do this, and double-check how much you need to pay to clear your debt.
- Start paying off your new loan as detailed in your loan agreement.
» MORE: How to get a personal loan
Does refinancing a loan affect your credit score?
When you refinance a loan, you need to submit a new loan application. This involves a hard credit check which will appear on your credit file.
A one-off credit check is unlikely to have a significant impact on your score, but multiple checks within a short space of time could harm it.
This means that, on its own, refinancing a loan shouldn’t cause lasting damage to your credit score. And, as long as you make your loan payments on time and stay on top of any other credit commitments, your score could start to improve.
Why you might want to refinance a personal loan
It may be worth refinancing a personal loan in the following situations:
- If you can get a loan with a lower interest than your current loan. This may be because your credit score or financial situation has improved since your initial loan application. While a loan with a lower rate means you could pay less in interest overall, make sure you consider the term of the new loan. Borrowing over a longer period could make it more expensive than your current loan.
- If you want to lower your monthly payments. If you’re finding it hard to make your payments, taking out a loan with a lower interest rate or borrowing over a longer period could help make it more affordable on a monthly basis. But remember that extending the term means you would pay more in interest overall.
- If you want to “top up” your loan. If you need to borrow more money but don’t want to pay off two separate loans, you could take out a loan that will give you the extra money you need and pay off your existing loan. For example, if you have £2,000 left to pay on your current loan and you want to borrow another £1,000, you could apply to borrow £3,000 to cover both these costs. This means you would only have one monthly repayment to keep track of, but the new loan may have a different interest rate to your initial loan so it’s worth checking if this is the most cost-effective option for you.
The pros and cons of refinancing a loan
Here we look at some of the pros and cons of refinancing a personal loan.
Pros of refinancing a loan
- You could reduce the amount of interest you pay.
- You may be able to shorten the length of the loan term, which could mean you pay less interest overall.
- You could lower your monthly repayments.
Cons of refinancing a loan
- There may be early repayment charges to pay on an existing loan.
- You may extend the amount of time you’re paying back a loan, which can also wipe out any savings in lower interest rates.
- It will involve a new loan application and a credit check, which will appear on your credit file.
Alternatives to refinancing a loan
Instead of taking out a new personal loan to lower your costs, you might be able to clear it another way. If you have savings in excess of what you need for emergencies, this is generally considered the best way to clear existing debt.
If you want to refinance your loan because you’re struggling to make your monthly payments, you may want to speak to your existing lender first. They may be willing to agree to a new, more affordable, payment plan that means you wouldn’t need to apply for a new loan.
It may also be worth speaking to a debt charity for some advice if you’re not sure if taking out a new loan is right for you. They will be able to offer guidance on your situation and help you work out the best course of action.
Image source: Getty Images
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