What is Refinancing and How Does it Work?

What happens if your car breaks down and you need money to cover it? Or, what if you’d like to reduce expensive debt or replace your old stove with one that actually works?

In these cases, many people apply for personal loans to quickly cover emergency expenses, consolidate high interest debt, or fund a project, like a home renovation. 

In a hurry to get a loan quickly, many borrowers can gloss over essential details like the terms, rate, fees, and overall cost, which sinks them further into a cycle of debt that they struggle to handle. They forget to be cautious and remember that the devil is in the details when it comes to personal loans.

If you’re looking for a way to relieve the pressure of emergencies or debt, you’re not alone. But you do need to be proactive about finding a solution that’s in your financial comfort zone. You want to manage your debt without adding more or stressing about the debt you already have.  

A simple solution that’s likely to help you is refinancing. 

What is refinancing?

At the most basic level, refinancing is when you get to say ‘goodbye’ to your previous loan and ‘hello’ to a new one with better terms. 

By refinancing to a new loan with a lower interest rate or a shorter repayment period (or both), you can improve your financial situation. Best of all, you can refinance just about any type of debt, from mortgages to auto loans.

Pro tip: Wondering ‘When should I refinance?’ It’s common for borrowers to refinance when interest rates drop because of fluctuations in the market.

How does refinancing work?

Refinancing is similar to the process of shopping for a mortgage or for any other type of personal loan. You start by researching and comparing different lenders to find one that offers better loan terms than the one you currently have. You could possibly refinance with the same lender you got your first loan from, if it offers refinancing, or with a new lender. 

Once you’ve found a lender with terms that better fit your financial needs, apply. A lender will check your credit report, credit score, and your credit history to gauge your level of risk to help them understand your eligibility. If you’re approved, the lender will give you a new loan with new terms that you can use to pay off your previous loan. 

Are there different types of refinancing?

You bet. When it comes to refinancing, you’ve got options, each designed to meet different personal and financial needs. 

If you’re not sure what option is right for you, talk with your lender about the costs and benefits of each option first so you don’t waste your time or money. The primary options include:

• Cash-in refinancing: A cash-in refinance gives you the chance to put a substantial amount of money toward your loan principal. You can use the money from this loan for most major expenses, but it’s commonly used for home repairs and improvements. The lower your principal balance, the lower your monthly payments or your loan-to-value (LTV) ratio. LTV ratio is a measure mortgage lenders typically use to compare the cost of your mortgage with the appraised value of the property. The more money you put into your down payment (or principal), the lower your LTV ratio will be.

• Cash-out refinancing: With a cash-out refinance, you trade in your previous loan balance—in most cases on a mortgage—for a new one that’s bigger. With this arrangement, you get paid the difference between the amount you borrowed and what you owe on the home. While this option increases the total loan amount, it gives you immediate access to cash and you still own the asset.
• Consolidation refinancing: A consolidation refinance is similar to a cash-out refinance since you borrow a larger loan amount for the new loan at a lower interest rate. Instead of pocketing the cash, you pay it toward another debt that has a higher interest rate. By refinancing this way, you can pay down your remaining principal with significantly lower interest rate payments.
• Rate-and-term refinancing: Rate-and-term refinancing is the most popular option. With this kind of refinancing, you can swap the terms of your current loan for terms that are more financially beneficial to you. Voila! Better terms can mean lower payments and faster debt payoff.

Is refinancing worth it?

If refinancing will save you money and pay off your debt faster, it’s a good option. But there are pros and cons, just like with any big financial decision. Here’s a quick view:

How to determine if refinancing is right for you

There is no single correct path to refinancing your loan, but the following steps will help you come to the bargaining table better prepared.

Check your financial situation and credit score

Anyone can apply to refinance a loan, but that doesn’t mean they’re guaranteed to qualify for the kind of terms they want. Thankfully, you can take a few steps that can help you stand out in a good way. 

First, get a free copy of your credit report from AnnualCreditReport.com, which you’re entitled to every 12 months. A credit report is like a more in-depth version of a school report card—it shows your credit score, which is like a financial GPA. In contrast, your credit history is more like your grade records from past semesters. Lenders use this report to review how well you’ve paid back your past debts and to determine how likely you are to pay your bills on time and in full. 

Lenders will also check your credit score. The better financial track record you have, the higher score you’ll get, which will help you qualify for lower interest rates. 

What if your credit report and score could use some work? Think: past due debts you haven’t paid or a credit score of 640 or lower. If that’s the case, a refinance might not be the best decision for you right now. Why? You probably will not qualify for the rates you’d like, or you might not be eligible to get a new loan at this time. If you don’t qualify for lower rates or a short loan term, then it might not make the most financial sense for you to refinance.

Calculate savings

Before you commit to refinancing, you need to crunch some numbers to make sure it works for your financial needs. Use Upstart’s personal loan calculator to compare and contrast loan options to help you understand what your potential savings might be.

The bottom line

Refinancing can be one of the best financial decisions you’ll ever make, but it’s not right for everyone. If you think that refinancing might be the right  move for you, do some homework to make sure that you can handle it now and in the future. 

If you’re ready to refinance your auto loan, get started through Upstart by checking out your options.