Should I refinance my loans?

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Interest rates are once again at historical lows. During the last Federal Open Market Committee (FOMC) meeting on June 10th, the Federal Reserve “projected it would be appropriate to maintain the target range for the fed funds rate at 0 to 1/4 percent through at least 2022” (federalreserve.gov). While this news is not great for our savings accounts, it offers consumers a chance to refinance outstanding debt. Credible allows you to compare interest rates from multiple lenders. It’s fast, easy and won’t affect your credit score. Be sure to keep the following in mind while deciding whether refinancing is the best choice for you.

The benefits of refinancing.

Refinancing allows consumers to replace their old high interest loan with a new, lower interest loan. Consumers enjoy lower monthly payments as the interest rate decreases. Others may choose to keep their monthly payments generally the same, but pay off the loan faster and reduce total interest paid over the life of the loan. For my fellow visual learners, Forbes contributor Ryan Frailich does a great job illustrating and comparing these benefits using a Mortgage Refinance Case Study.

Lower payments or paying down loans faster sounds great, so why doesn’t everyone rush to refinance?

What’s the catch?

There are costs associated with applying for a new loan. With mortgages, consumers must weigh how long it will take to recover these costs (it could be years) and whether they intend to move during that time. Sarah Davis writes for Money Under 30, “I would recommend refinancing your mortgage if current interest rates are at least 1% lower than your existing rate, and you plan on staying in your home for another five years”. Following this general rule will help you decide if refinancing is worthwhile.

Another factor (illustrated in the case study) to consider is the extension of your debt repayment period. Let’s say you’ve paid your current 30 year mortgage for five years. If you refinance with another 30 year mortgage to take advantage of lower monthly payments, it will take longer to repay the loan (35 years). This will also increase total interest paid over time unless you make extra payments to pay the loan off faster. In this case you are trading off total savings to free up cash flow in your monthly budget. This is something to factor when refinancing student loans as well.

Refinancing student loans after you’ve graduated and secured a stable job is often beneficial. Interest is highest in the beginning of the repayment period when outstanding loan balances are high. A lower rate can generate significant savings. Though, as ‚ÄčForbes contributor Andrew Josuweit points out, there are some situations where refinancing student loans is not ideal. Federal loans have access to income driven repayment plans and loan forgiveness programs. You will lose access to these benefits if you refinance to a private student loan. Lastly, savings on lower interest rates might be minimal after factoring in loan fees. See if your lender provides zero fee refinancing and shop rates from different lenders.

The role your credit score plays.

The interest rate you pay on loans isn’t solely based on the market or fed funds target rate. Credit scores are also a factor. Maintaining a high credit score will increase your odds of being able to refinance at a lower rate. Credit Sesame offers free, helpful tools that monitor your credit score and report. When you sign up for the basic plan you’ll receive a monthly credit score from Transunion, plus feedback on each factor that affects your score and tips for improving your score. 30% of a consumer’s credit score is based on making prompt payments while another 30% is based on the amount of outstanding debt balances. Using a credit card for small purchases, like gas or groceries, and paying the balance in full by the due date will help you build credit and avoid paying interest on these purchases. It shows you pay on time and the amount of debt you carry forward is low or zero.

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