Refinancing Loans

We Should Always Look Ahead and Not Backward When Considering Refinancing

There are two different types of loans that we can take out. The first is what we could call a primary loan, where money is borrowed for some purpose or other that does not involve paying out an existing loan or loans. The second type is called a refinance, where some or all of the proceeds of the loan is used to pay off or pay down another loan or other loans.

Primary loans are pretty simple, as we specify how much money we wish to borrow and if the purchase is justified and the rate is acceptable to us, we may benefit from these loans. Loans that involve refinancing may also seem simple, but there are some additional considerations that we need to be aware of to get the most out of them.

The first thing to account for is a reluctance that some people have with refinancing loans, where they may hold a bias or even a strong bias against them. This might seem odd, but there is a view out there that is even held by a lot of people who write on the topic that we should look to avoid refinancing.

RefinanceWe might feel that doing a refinance involves admitting that we have not managed things well in the past, and in that’s actually often the case. However, whether the refinance results from good financial management or poor decision making doesn’t matter at this point, after it has happened that is, and any attempts to look to turn our heads away from what needs to be done or what may benefit us is not sound reasoning at all.

Instead, we always need to be looking forward, and while we should always look to learn from past mistakes, such as not running up our credit cards so much the next time, or choosing a better option in the first place when we get these primary loans, we cannot change the past. We can change the present and the future though and this is what we need to focus on if we’re looking to help ourselves and not add another bad decision, not acting when we should, to the previous bad ones.

It is not always the case though that refinancing arises out of bad decision making, even though less than optimal choices are often involved. A good example of this not being based upon poor choices is when we have a loan and unforeseen circumstances arise that reduce our financial capacity, and it is certainly wiser to choose lowering our payments and spreading the loan over a longer period of time if this is required.

Otherwise, we may face hardship and we may even default on the loan. It is imperative to exhaust all possibilities before we are forced to fall behind on our loan payments, because this will hurt our credit score to the point where escaping from a bad situation may end up no longer being practical or even possible.

Pairing our Debt with the Right Loan Product

There may also be situations where we may first place purchases on our credit cards and then pay them off later by design, and this could involve taking advantage of the interest-free period on our cards and then pay off the cards with another loan once this expires.

Almost all credit card refinances involve paying the higher interest on the cards for a period of time though, and it’s not that we can take out an installment loan every time we get a few hundred dollars’ worth of credit card debt. Installment loans usually come with minimums of a few thousand dollars and we need to owe enough to meet their threshold, and this can take a while in some cases.

We should always look to borrow at the lowest rate possible and choose the loan product with the lowest interest, and even if we could take out installment loans for very small amounts, this just wouldn’t be practical. We don’t want dozens of loans out there to manage, and there’s actually no reason for this because we can usually move the debt to a lower interest rate revolving loan, called a line of credit.

If we just use installment loans to pay off accumulating credit card debt, we will only do so occasionally, and in between the periods we’re paying the higher rate on the debt on the credit cards. After we refinance this way, the next time we need to borrow we’re back on the credit cards again, saving up so to speak for another refinance.

Credit cards are also the most dangerous loan product out there, by far actually, and this is because credit card issuers extend credit with far less regard to our capacity to repay. Even high interest loans and lines of credit from subprime lenders pay a lot more attention to our having this capacity, even though they may be more flexible than banks.

Credit card companies, often the same institution that place much stricter controls on their other loan products, base decisions on extending more credit almost solely on our history with them, our internal credit so to speak, and will often no longer look at income or capacity in their decisions to increase their clients’ credit limits.

We can then see ourselves in situations where if we used all of the available credit card available credit that has been provided to us, or anything close to that, we may end up crippling ourselves financially. If we maintain this borrowing on lines of credit, where the lender actually does have our back a lot more, we can stay within our actual capacity to repay much better.

There is actually a view among many in the lending industry that we should always pay off revolving debt with an installment loan though, and there is at least a façade of sensibility behind this, but this view is actually too superficial.

Revolving Credit is Not the Problem, Too Much Spending Is

When we see people conduct their borrowing in a way that we consider to be mismanagement, we may conclude that these people don’t have the discipline to manage revolving credit, where installment loans at least force the clients to pay off the money owed on a schedule and in time.

The fear here is that if we replace revolving debt, credit card balances for instance, with more revolving debt, putting it on a line of credit, they may end up maxing out both and struggle even more to pay it off. If they do have a penchant to do this, this will happen regardless, and even though banks often force borrowers to close the credit card accounts that are being refinanced, people can get new accounts pretty easily.

In fact, after you refinance revolving debt into installment debt, this tends to improve your ability to qualify for new revolving loan products, due to this improving your credit score generally, and if we have a real spending problem, and we like to borrow more than we should or more than we’re able to repay, we will get ourselves in trouble either way.

The installment refinance, if anything, increases the risk, as the next time we need to borrow, we’re back to putting this debt back on credit cards again. This causes us to pay more interest than if we had used a revolving product that not only refinances our previous debt but also allows future borrowing needs to be accommodated if we qualify.

The pointy edge of credit card debt is the higher amounts that go to interest and less to principal when we make a given payment amount, and this amplifies the impact of over-borrowing and will lead to us getting into more financial trouble sooner.

This does not mean that we should avoid paying off revolving debt with an installment loan, and in many cases, this is the best choice, but it all depends on the situation. While there are no real hard and fast rules for this, at a minimum, we need to consider both our present situation and our future one, and it is focusing on the present too much and often exclusively that creates the biggest problems.

Our example of getting an installment loan to pay off credit card debt is a good one, as we and our banker may both be thinking that this has solved our problem or even eliminated it by providing a fresh start, with a lower rate and more manageable payments, but we still need to make sure that we are looking ahead as well.

Lenders really don’t provide much advice on managing our personal finances well, and this is all left up to us really unless we have a good financial advisor. Even financial advisors don’t go I to this problem in much depth, and it is incumbent upon us to look deeply enough into our financial situation to find real solutions.

This essentially comes down to managing our spending, and especially if we have let ourselves get into deficit situations without a clear short-term plan to rectify them, we’re simply going to need to cut down. We should only be borrowing money when we truly can afford the payments, and while installment loans and lines of credit require us to at least demonstrate to the lender that we do have this means, with credit card borrowing, all bets are off generally and they can be used as a means to financial destruction if we are not careful.

Lines of Credit Are Generally the Best Choice to Refinance

Each type of loan product has its place, even credit cards, and we need to always consider which one fits our needs the best in our situation. Initially placing debt on a credit card to take advantage of the rewards they provide as well as the interest-free grace period that comes with them can be a great idea, but leaving this debt on there and pay their higher interest rates is not and should be avoided when possible.

Lots of people do not avoid this though, and while some may not have a line of credit or would qualify for one, there are plenty of people who do have one and don’t use it properly, or more commonly, they do not have one but could and should.

Once on our line of credit, there will be a certain threshold that may be reached where we may want or need to free up some room on it or simply re-assign it to an installment loan, and we ,ay prefer doing this over extending the line of credit to add the desired borrowing capacity, but this needs to be done in a thoughtful way to ensure this is the best option for us.

If we are diligent enough, and given that the rates are similar, there is no real advantage to moving it to an installment loan, even though a lot of bankers may convince you otherwise. We need to keep in mind that these people receive at least recognition for opening new lending products, and are usually compensated for it as well, so we should not be surprised that they have a bias toward refinancing with an installment loan over simply increasing our line of credit.

Installment loans are less flexible though, and we do not get the benefit of having new credit being made available as we pay down a revolving product. There is also the loss of payment flexibility that revolving products have, where we can essentially set our own payments, including making no net payment at all and even a negative payment, where with installment loans the minimum payments are fixed and involve paying both principal and interest on an amortized schedule.

If refinancing with an installment loan is desired though, and we’re happy to forego these extra features of a line of credit then such a choice will be fine, although there’s always going to be some risk of regret.

If, for instance, you choose to refinance with an installment loan, and then run into financial difficulty later, you may end up defaulting on the loan but may have been all right had you held the debt on a line of credit. If you are in a spot where you can’t make the next payment, or even several of them consecutively, as long as you have enough available credit to fit in your interest payments over the time you need to take a break from paying, you are fine.

If you are of the sort that cannot be trusted, even by yourself, and if you remain with revolving products you won’t know when to stop and will end up in real trouble, and you also have the resolve and the confidence to limit your access to revolving credit going forward, an installment loan refinance can at least seem to make sense.

We do need to ask ourselves how we may have the discipline to restrain ourselves from opening new credit products but not restrain abusing our current ones. Perhaps there is a segment that can do one but not the other, and the action required to open a new product or products does require additional initiative, but this barrier has to be effective to justify this choice, and very often it is not.

The only other persuasive reason to do this is if you actually do improve your rate meaningfully, and enough that you are willing to forego the added usability and the lower risk of lines of credit, this can also be a good choice. We do need to make sure that we are pricing the costs of giving up these benefits appropriately though, which will vary according to your individual situation and needs.

Otherwise, it actually makes more sense to use lines of credit to refinance debt, even with refinancing installment debt of a similar or higher rate. The benefits that they tell us that installment refinances possess are lowering your rate and lowering your payments. They may lower your payments over what you were paying with another installment loan, but lines of credit effectively lower payments even more, as you simply choose what payment you want and can choose a different amount with each payment as needed, with ease.

If the interest rates are similar, an installment refinance won’t help you in this regard, and even though they may be lower than what you are paying on your credit cards, the decision is between the installment loan and a line of credit, and if they are around the same rate, they will provide around the same interest savings.

Lines of credit can also be used as a savings account of sorts, where we may place all of our extra money on it and save interest on these amounts that would otherwise be payable. You can’t do that with a loan, and when you put more on it you cannot ever take it back without refinancing the loan entirely.

Doing this can end up saving the borrower some real money, and this reason alone tips the scale toward refinancing with lines of credit, and together with its superior payment management, should make it the default option unless there are good enough reasons to trump these benefits.

We might therefore think that most refinances involve using a line of credit to do it, but this is far from the case and almost all refinances involve using installment loans. Those who do use lines of credit for this almost always need to come to this conclusion without any guidance, since this guidance is so skewed toward selling more loans.

Your banker very likely will not understand all of this well enough, and attempts to request a line of credit refinance may be met with some resistance, because this is how they are trained. If it actually does make sense to refinance with an installment loan, we’ve at least thought about this and we should never just take someone’s recommendation without proper consideration.

In spite of what we may be told, refinancing debt using a line of credit is generally the better choice, and while there are exceptions, we should make sure that our situation really does justify it if we are seeking to use an installment refinance instead.

Refinance FAQs

  • Why do people refinance?
    Home ownership builds wealth over time by the value of the home increasing as well as by paying down your mortgage. This wealth can be borrowed against and many people have debt at a higher rate or wish to borrow and would pay a higher rate otherwise. Refinancing allows people to borrow at a lower rate as well as lower their overall payments.
  • Is refinancing a good idea?
    Refinancing is actually always a good idea if there is a need, even though what we use the money for may not be. If you have debt or wish to borrow, it is always wise to borrow at the lowest rate possible, which refinancing always provides. In a lot of cases, refinancing will even save someone from insolvency or it may even save them from losing their home.
  • What happens when you refinance your home?
    Refinancing your home involves adding to the principal amount of your mortgage, extending the amortization of your mortgage, or both. Your mortgage payments become larger as you add to it, although you can spread this out by choosing a longer amortization, which is the maximum amount of time you have to repay your mortgage.
  • When should you refinance?
    Refinancing costs money so this should only be done when the benefits of the refinance is greater than the cost to do it. The benefits of a refinance include saving money on interest, borrowing for something that you would not be able to have otherwise, and lowering your overall payments and freeing up cash.
  • Does refinancing start your loan over?
    Refinancing does reset your loan by adding to its balance, adding to the time you have to repay it, or both. This is not like starting over again though, where the time you paid on it has been somehow wasted, it is more of a refresh and what is being refreshed is your overall financial picture which the refinance serves to improve.
  • Can I get money back if I refinance my house?
    The major reason why people refinance their houses is to tap into some of the equity that they have built up, which is called an equity take out refinance. This money can be used for any purpose but it only makes sense to do this when you need to borrow, to pay off higher interest debt, or to renovate or remodel your home for instance.
  • When can you refinance a loan?
    You can generally refinance a loan anytime, although depending on the terms of your mortgage, there may be prepayment penalties involved where you need to compensate the lender the difference between the higher rate you had and the lower rate of the new loan. It is still generally worth it though if there is a good enough reason for the refinance.
  • Does refinancing hurt your credit?
    Refinancing generally improves your credit a lot, given that it improves your financial situation and credit bureaus do a pretty good job of making adjustments in your score to reflect better positions. If your cards are maxed out for instance and you pay them off and free up available credit, you are in a far less risky predicament, which is what the score cares about.
  • How much does it cost to refinance?
    Refinance costs vary quite a bit depending on the circumstances. There are standard fees involved such as legal and appraisal costs, plus whatever costs are involved to get out of your old mortgage so to speak. If you agree to certain mortgage terms, your lender won’t allow you to simply switch to a better rate in the middle of your term without compensation.
  • How often can you refinance?
    There are few restrictions on how often you can refinance, although practical considerations will place strict limitations on how often it makes sense to do it. You don’t want to refinance every time you rack up a little debt because refinancing does costs money, and it makes sense to wait until you have enough to refinance to justify the costs.
  • How long does it take to refinance a house?
    Refinancing your house usually takes several weeks to complete, although this does differ among lenders. The time this takes depends a lot on the speed of the processing time of the lender and how quickly borrowers can provide necessary documents. There is also usually a backlog of applications on the lender side which can add to the time it takes.

References & Scholarly Articles for Refinance

Books on Refinance

  • So You Want to Refinance: An Insiders Guide to Refinancing Adjustable Rate Mortgages and Home Loans (Author: Kristina Benson, Originally published: September 2006)
  • Keys to mortgage financing and refinancing (Author: Jack P Friedman, Originally published: 1989)
  • An Insider’s Guide to Refinancing Your Mortgage: Money-Saving Secrets You Need to Know (Author: David Reed, Originally published: September 15, 2008)
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