Borrowing money for a purchase, such as a car or home, comes with its fair share of pros and cons. While it enables you to afford upfront what you otherwise wouldn’t be able to, the monthly payments can feel constricting. Luckily, you may not be bound to the same conditions of a loan forever.
This is where refinancing comes to play. We are going to cover the meaning of refinancing, the importance of lowering your interest rate, and how to decide when is a good time to refinance.
What does it mean to refinance?
Refinancing is literally swapping your loan out for another loan, whether with the same lender or a different one. People refinance for a few different reasons, perhaps to lower the monthly payment, but the most important objective of refinancing should be to lock in a lower interest rate.
While lowering your monthly payment can be helpful in the short-term by freeing up a bit more cash, don’t get tricked into significantly lengthening the term of the loan simply to lower your monthly payment. You will see that the total interest paid over the period is significantly more. The primary objective should be to lower your interest rate, and the monthly payment will come down as a result of this.
Understanding compound interest
Compounding interest is an invaluable tool when you are investing. It is the concept of interest on interest, where your returns in one period then lead to an increasing amount of interest in the next period. However, when it’s working against you it can be the largest detriment to building wealth.
The two most important variables when considering compound interest are the interest rate and time. Considering a debt, the longer you extend the loan means there is more time for the interest to compound on itself. This means it is growing into more and more debt. This is why it is crucial to consider the length of the loan when you take on debt.
And then comes the interest rate, which is essentially the rate at which the debt is growing. You can think of the interest rate on a loan as essentially the reverse of what it would be for your savings account. This is why credit card debt can be such a slippery slope. While a mortgage payment may range between 2-5%, credit card companies will attach a whopping 20-30% interest.
Let’s look at an example of an auto loan for interest rates and loan lengths can make a difference.
Example Auto Loan
Let’s say you purchased a used 2018 Chevrolet Tahoe for $40,000. You financed through the dealership, and they weren’t offering any 0% interest rate deals since it was a used vehicle. With $4000 down, you locked in a rate of 7.6% EAR interest.
You have two options for term-lengths, a 60-month and a 72-month. For a 60-month loan on the remaining $36,000, your monthly payment is $723.08. For the 72-month, the monthly payment is $624.19. You decide on the 60-month term with payments with $723.08.
For the sake of simplicity, let’s say you haven’t made a single payment yet. After a stern “come-to-Jesus” talk with your spouse the night you make the purchase, you realize that you could potentially have better terms on the loan. You talk to your local banker the following week about your options, because the dealership offered a 72-month term with payments of only $624.19 and that seems a bit easier to swallow. Your banker knows a few things about compounding interest, and she advises you to submit an application to see if you can lock in a lower rate.
The refinance loan is approved, with an interest rate of 4.3% for a 60-month term, compared to the dealership rate of 7.6%. This 60-month term with 4.3% interest lowers your monthly payment to $667.88 compared to your 60-month term with the dealership of $723.08, a $56 monthly difference.
You may notice that this is still a higher monthly payment than the 7.6% interest 72-month term offered by the dealership, which was $624.19. But, this is where the interest rate matters. Take a look below to see the difference in interest paid over the life of the loan.
|Terms||Monthly Payment||Total Interest Paid|
|4.3% int, 60-month||$667.88||$4,072.78|
|7.6% int, 60-month||$723.08||$7,384.68|
|7.6% int, 72-month||$624.19||$8,941.59|
What would have seemingly been a good option, to pay $624.19 per month at the 7.6% rate vs. $723.08 per month, translates to a difference of $1700 in total interest paid over the course of the loan. And once the refinance is made to a lower interest rate, the difference between the 7.6% int, 72-month loan and the 4.3% int, 60-month is a difference of almost $5000 in interest paid.
This is the power of compound interest and how it can work against you if you are not careful. With refinancing, you have the ability to change the terms of the loan both in terms of interest rate and timing to better situate yourself for success.
Things to consider before refinancing
Refinancing may sound like the magic ticket to putting more money in your pocket every month, but there are always things to consider.
Read the fine print. When evaluating your current loan and the terms of a new loan, just make sure you are reading through to understand what additional fees or charges may occur in addition to any terms of the loan. The payoff amount on your current loan may be slightly larger than the remaining balance. For mortgages, you will likely have to pay the closing costs as the deed is technically changing hands from one lender to another. Some banks may charge an application fee for a refinance. These are some of the small things that can add up and make a refinance not worth it if you can’t significantly change the interest rate.
Timing. You will want to evaluate where you stand on your loan. This is when it helps to view an amortization calculator to understand how much interest you still have remaining to pay. Refinancing later a loan may not be worth it once the fees and costs are associated, even if you are able to lower your interest rate by a couple of percentage points. When it comes to auto loans, some lenders won’t refinance loans for vehicles older than a certain year.
Credit Score. Before refinancing, you will want to make sure you have an idea of your credit score. We have more information on the breakdown of credit scores and a few ways to build it here. When you apply for a refinance, the lender makes a hard inquiry of your score, which does show up on your credit report. Overall, the higher your score, the better chance you will have at being approved and with a better interest rate.
Is now a good time to refinance?
Knowing what we now know about compound interest, it makes sense to refinance as early in a loan as possible. This is generally correct. However, it is important to consider the items listed above as well as the general macroeconomic environment.
Interest rates are tied to the Federal Reserve and US Treasury note rates, so having a basic understanding of whether interest rates are “low or high” will help you determine when a good time may be.
Jerome Powell, the Chairman of the Federal Reserve, communicated in September 2020 that the Fed had plans to maintain near-zero interest rates through as far as 2023. This means that there is at least a moderate runway with lower rates before we can start to expect rate increases.
Overall, there is no such thing as “perfect timing”. You should consider a refinance when you think you are ready. Being ready means that you understand where you stand in your loan, have an idea of what your credit score is, and know what terms and conditions may apply if you choose to refinance.
Compound interest can significantly hinder your ability to build wealth, so it’s important to be familiar with your debts and know where you could stand to improve your terms. Refinancing, when executed correctly, can be an essential tool to improving your terms and setting yourself up for financial success.