What Is Refinancing?

Quick Answer

Refinancing is when you replace one loan with another one, typically with the aim of locking in a better interest rate, lowering monthly payment or accessing your equity. Depending on the type of debt you’re refinancing, there are pros and cons to consider before you refinance debt.

Couple getting financial advice

Refinancing is the process of replacing an existing loan with a new one. It's typically done to improve terms for the borrower, such as getting a lower interest rate or shorter loan term. For instance, you might refinance an auto loan with one that has a lower monthly payment, or refinance a mortgage loan to reduce your interest rate and pay less over the life of the loan.

Here's what you need to know about how refinancing works for different types of debt, the pros and cons of refinancing and how to refinance a loan.

What Is Refinancing?

Refinancing is the process of getting a new loan to replace an existing loan, often to take advantage of an improved credit score, lower interest rates or other more advantageous terms. A refinance typically happens when a borrower wants different loan terms to make the debt easier to pay off, reduce the total amount paid, allow them to cash out some of their equity or speed up debt payoff.

Why Refinance?

There are several reasons people choose to refinance debt. Refinancing is typically done using the following types of refinances to achieve a few primary goals:

  • Rate-and-term refinance: The goal of a rate-and-term refinance is to gain advantageous terms with a new loan. For example, if you have a personal loan with a 16% interest rate and you're able to qualify for one with a 12% interest rate, you could refinance the debt by taking out the 12% rate personal loan and using it to repay the original personal loan.
  • Cash-out refinance: With a cash-out refinance, you take out a new loan to repay your current one with the aim of tapping into the equity you've built in an asset (typically a home).
  • Cash-in refinance: With a cash-in refinance, you make a large lump-sum payment on an asset (typically a home) and then take out a new, smaller loan to cover your remaining balance. Benefits to a cash-in refinance could include scoring a lower interest rate, lower monthly payments or paying off your debt faster.

Examples of Refinancing

Here are some examples of what refinancing can look like for a variety of debt types.

Refinancing a House

When you refinance a mortgage, you take out a new home loan and use it to repay your old one. Two common reasons people choose to refinance their homes are to access equity (cash-out refinancing) or to lower their interest rate (rate-and-term refinancing). In both cases, it's most advantageous to refinance your home loan if rates were higher when your mortgage originated than they are now.

Tapping into equity through cash-out refinancing can help you achieve a number of goals. For example, you might use that money to complete home renovations that increase the value of your home. Or, you might use that equity to buy an investment property or another home.

Whatever your plan for the equity, it's worth considering that when you tap into the money in your home, you're decreasing your equity and increasing your debt. That comes with its own risks.

Refinancing an Auto Loan

An auto loan refinance is when you take out a new loan to pay off the balance on your existing auto loan. The goal is typically to lower your interest rate to reduce your overall interest costs, or to lower your monthly payments to make repayment easier to manage. For example, you could choose to refinance your auto loan when rates are down or if your credit score has improved, which could help you access better terms.

You may also refinance to an auto loan that has a shorter repayment term if you'd prefer to finish paying off your loan sooner rather than later. A shorter repayment term will usually increase the amount of your monthly payment, however.

Refinancing Student Loans

Refinancing student loans typically refers to taking out private student loans and using them to repay your federal student loan debt. Or, you could refinance a private student loan with another private student loan.

If you have good credit, refinancing your student loans could bring savings on interest and possibly the opportunity to reduce your monthly payments. But proceed with caution when evaluating whether to refinance federal student loans.

While refinancing to private student loans may offer savings, especially if you have good credit, there's also a lot you stand to lose when you refinance federal student loans. Namely, you will no longer have access to the protections and benefits federal loans offer, including student loan forgiveness programs and income-based repayment.

Refinancing Credit Card or Personal Loan Debt

Refinancing credit card debt or personal loan debt usually means taking out a debt consolidation loan (also a personal loan) to pay off your credit balances. Because credit card balances and personal loans sometimes come with high APRs, consolidating using a loan with a better rate can make a big difference in making repayment more manageable.

Pros and Cons of Refinancing

Here are some pros and cons of refinancing to consider before you decide whether it's a good option for you.

Pros of Refinancing

  • Save money on interest: One of those most common reasons to refinance any form of debt is to achieve a lower interest rate. Homeowners often refinance their home loans when rates go down significantly to save money. As another example, a debt consolidation can refinance multiple higher-rate debts with one loan that has a lower interest rate and predictable monthly payment.
  • Lower your monthly payments: Another possible benefit of refinancing is achieving lower monthly payments. If your monthly debt payments are higher than you can comfortably manage, refinancing could give you more breathing room in your budget.
  • Make getting out of debt easier: Refinancing multiple debts into one loan with lower interest and predictable payments can make paying off your debts an easier feat. Used in combination with other debt management strategies, this can be a big win for your finances.

Cons of Refinancing

  • Could increase overall cost of debt: If you refinance a loan to one with a longer loan term and lower monthly payments, you'll most likely end up paying considerably more in interest over the life of the loan. Also, if taking out the new loan requires you to pay closing costs (which is common when you refinance your home), you should consider those fees when evaluating the overall cost of refinancing your debt. You may not see a financial benefit if you plan to sell the home in the near future, for instance.
  • Monthly payments could increase: Depending on the terms of the loan you take out, your monthly payments could also go up; for example, if you refinance a loan when rates are higher, take out a loan with a shorter term or refinance a loan with a larger one.
  • Could make it easier to get into more debt: In the case of refinancing multiple debts into one consolidation loan, you could be opening yourself up to fall into more debt. For instance, if you refinance multiple credit card balances into one loan but then continue to use the credit cards you paid off, you could end up in a worse situation.
  • Credit impact: Refinancing debt can impact your credit. When you refinance debt, you apply for a new loan to repay an old one. That can lead to a hard inquiry on your credit report, which could have a small, temporary negative impact on your score. A refinance can also reduce the average age of your credit accounts, because you're replacing an older debt with a newer one. That, too, can have an impact on your credit. That said, if your previous loan terms were unaffordable and refinancing helps you maintain on-time payments, it could potentially help—or at least avoid hurting—your credit over time.

How to Refinance a Loan

The steps you'll take to refinance a loan depend on the type of debt you want to refinance and your goals for refinancing. Your first course of action is generally to rate shop multiple lenders and look for loan offers that you're likely for based on your credit, income and other factors. Seeing what's out there can give you a sense of whether now's the right time to refinance.

If you find loan offers that work for you, hit pause before you proceed. Consider talking to your current lender to discuss your goals. You could let your lender know that you're considering refinancing, and inform them about any offers you have that include lower interest rates or fees. You may be able to negotiate with your lender to change the terms of your current loan. This spares you some of the work involved with refinancing, and it helps you limit new accounts on your credit report.

The Bottom Line

Be it a personal loan, mortgage, auto loan, student loan or other debt, refinancing can help you accomplish a range of goals. It's always a good idea to weigh your options before you refinance, and get a sense of the options available to you before you decide to proceed.

Before you decide to refinance, check your FICO® Score for free through Experian. Your credit scores have an impact on how easy it will be to qualify for a new loan, as well as the rates and terms you may receive.