Refinancing a personal loan: What it is and how it works

A personal loan is a convenient tool to finance emergency expenses. Sometimes, due to the urgency of funds, a borrower might not assess the ability to repay the loan in future. In such a scenario, refinancing a personal loan is an effective tool to repay the existing debt and set revised terms for the new loan.

What is refinancing a personal loan?

Refinancing a personal loan is the process of getting a new loan to clear previous loans. This is mainly preferred by borrowers who want to reduce their monthly loan payments. This new loan will typically offer lower interest rates and better repayment options than the existing loan. A refinance may also be a long-term loan with lower monthly payments, making it convenient for the borrower to make payments.

How does it work?

You can take a new loan to pay off an existing loan, which is referred to as refinancing. In such a scenario, the new loan amount is used to pay off the present loan. After paying it off, you must adhere to the new loan agreement. Hence, it becomes important to get a refinance loan with a lower interest rate and better repayment terms to make monthly payments comfortably when compared to the previous loan.

How do you refinance your personal loan?

Step 1: Before beginning the refinance process, verify your credit score and finances to evaluate your ability to take a loan.

Step 2: Choose a lender according to your needs and submit your loan application. The application will include your income details, personal information, existing loans, and other debt.

Step 3: The lender will verify your application and documents. Upon successful verification, the lender will approve your loan, and you will receive the necessary amount to repay your previous loan.

Step 4: Once you repay the previous one, the new loan terms and conditions kick in, and you must make payments accordingly.

Types of refinancing

1. Cash-out refinance: In this type of refinancing, you can borrow an amount greater than the existing loan. The difference between the new loan and the previous loan is given in cash, which could be used for other needs such as debt consolidation, home renovation expenses, etc.
2. Rate-and-term refinances: This loan is given in accordance with the interest rate or the tenure of the existing loan. You can opt for this type of refinancing to get low interest to suit your financial needs.
3. No-cost refinance: In this refinancing option, the lender will cover closing costs by charging a higher interest rate or adding it to the new loan. This option will help to manage upfront costs.
4. Streamline refinance: This is mainly applicable to government-backed loans. It aims to simplify the refinancing process by reducing paperwork.

When should you refinance your personal loan?

1. Improvement in credit score: In such a scenario, you might get better loan terms as lenders will provide favourable interest rates, tenure, etc.
2. Interest rate: If you are getting a lower interest rate on the new loan than on the previous loan, you can consider refinancing your personal loan.
3. Co-applicant: If you wish to change the terms of your loan by adding or removing a co-applicant, you can refinance your personal loan. Add or remove a co-applicant from your loan at your convenience.

Drawbacks of personal loan refinancing

1. Long repayment period: A refinanced loan usually has a longer repayment period, which might lead to higher interest costs in the long term.
2. Added costs: Getting a new loan may include expenses such as the closing cost of the existing loans.

Personal loan refinancing is a suitable option in the financial landscape where an existing loan burdens the borrower. Borrowers should opt for it when they feel that a new loan will ease their pockets. However, avoid getting into the cycle of getting loans to repay existing loans, as this may lead to higher interest costs in the future.