When you take out a personal loan, you’ll be told how much you need to repay each month, the interest rate charged, the length of the loan, and any early repayment fees that will be charged.
You may have taken the loan out for a number of reasons, from paying down other debts to using the money for home improvements or a new car. But during the term of the loan it might be possible for you to replace the loan with a new – cheaper – loan, which can save you money overall. Here we explain exactly how a refinance loan works, with a step-by-step guide to refinancing, the pros and cons, and the best alternatives.
What is refinancing?
Refinancing a loan basically involves using a new loan with a lower interest rate or a shorter length to clear 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.
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How to refinance a personal loan
In order to take out a refinance loan there are some steps you’ll need to follow.
- Shop around to see if you can find a new personal loan, with a lower interest rate than your existing loan. Be sure to include the length of the loan and any early repayment charges when calculating the overall cost.
- Use an eligibility checker 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.
- Apply for the new loan and use this money to clear your existing personal loan. You must contact the lender of the first loan before you make the payment – it should let you clear the loan but there may be some charges to pay.
- Close your previous loan and stop making payments towards it.
- Set up regular payments for your new loan and start paying it off.
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Why you might want to refinance a personal loan
The main reason for refinancing a personal loan is to lower the overall amount of money you’re paying out. If the new loan is going to cost you the same as the older loan, there’s no point in refinancing.
You only want to refinance if the loan is cheaper overall, as this will mean you save money and you should clear the loan sooner. If your credit score has improved and you’re now eligible for personal loans at cheaper rates, this could be a good opportunity to refinance your personal loan to cut down on costs. Similarly, if the market is going through a competitive spell and providers are cutting rates, this could be a good chance to pick up a cheaper loan – if you’re approved.
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
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.
The best 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.
You could also look at taking out a different type of credit to clear your personal loan, such as a credit card. However, there are risks involved. Unless you’re able to find a credit card with lower costs than your personal loan, which you know you’ll be able to clear, this method is unlikely to save you any money and could end up costing you more in interest and charges.
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