15 - The World of Refinancing: When Does It Make Sense?

Could you be paying less on your car loan or mortgage? In this episode, we explain the pros and cons of refinancing. It can be a powerful tool to save money, but it's not the right move for everyone. We'll discuss the two main reasons to consider refinancing—an improved credit score or a drop in market rates—and teach you how to calculate your "break-even point" on closing costs to see if it's truly worth it for your financial situation.

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Transcript

Episode 15 | The World of Refinancing: When Does It Make Sense?

00:00:00 Daniel Hill: So, Shanna, imagine someone who bought their first car just a few years ago. They were young, maybe didn't have a long credit history like we've talked about, and they were just so excited to get the keys that they took whatever financing the dealership offered them.

00:00:18 Shanna Browning: Been there! So I think a lot of us have probably been in that same exact situation. You're focused on that car, not the loan.

00:00:25 Daniel Hill: You just want the keys. You want to drive out. But now it's three years later. They've been making their payments on time, their credit score has improved significantly, and they've heard on the news that interest rates are lower than when they first bought the car.

00:00:41 Shanna Browning: Oh, yeah. And they're probably looking at their monthly car payment wondering, am I really stuck with this loan for the next three years and this car payment, or is there something I can do about it?

00:00:50 Daniel Hill: And that is the perfect question. And I have the perfect answer - Yes!

00:00:56 Shanna Browning: Yes.

00:00:57 Daniel Hill: There is often something you can do about it. It's called refinancing, and it can be a powerful tool not just for auto loans, but for mortgages as well.

00:01:07 Shanna Browning: That's right. Today we're going to talk about that breakdown and what refinancing is when it's a smart move and what pitfalls to avoid.

00:01:24 Daniel Hill: Welcome back to Making Sense of your Cents I'm Daniel Hill.

00:01:28 Shanna Browning: Hi friends. And I'm Shanna Browning. And today we're going to talk about a financial do over for your biggest loans. We're talking about refinancing.

00:01:37 Daniel Hill: We'll explain what it means, explore the most common reasons to do it, and give you a checklist to help you decide if refinancing your mortgage or your auto loan is the right move for you.

00:01:48 Shanna Browning: Okay, Daniel, let's start easy. Let's start simple with a simple definition for someone who's never heard the term refinancing. Tell me what it is.

00:01:58 Daniel Hill: Well, Shanna, refinancing is simply the process of replacing an existing loan with a new one. You're taking out a brand new loan to pay off and close out your old loan. The new loan will have different terms, and the goal is for those new terms to be better for you than the old ones were.

00:02:16 Shanna Browning: I got you. So you're not just changing a due date on your current loan. You're literally paying off the old debt with the new debt.

00:02:22 Daniel Hill: That's a perfect way to put it. You're starting fresh with a new lender, or sometimes even with the same lender, but under a completely new loan agreement.

00:02:32 Shanna Browning: But why would someone want to do that? Like, what's the main benefits people are looking for when they refinance?

00:02:38 Daniel Hill: There really are three primary goals. The common one is to secure a lower interest rate. This is the big one. If interest rates in the market have dropped since you got your original loan, or if your own credit score has improved significantly, you may be able to qualify for a much lower rate.

00:02:58 Shanna Browning: Well, let's talk about what low interest rate means when you pay less money to the bank over the life of the loan.

00:03:04 Daniel Hill: Exactly. It can lower your monthly payment, but more importantly, it can save you thousands or even tens of thousands of dollars in interest, especially on a mortgage. The second goal is to change the loan term. Maybe you want to pay off your house faster. You could refinance from a thirty year mortgage to a fifteen year mortgage. Your monthly payment might go up, but you'll be debt free decades sooner.

00:03:33 Shanna Browning: Or if you think about it, you could go the other way, right? If your budget is tight, you could refinance for a longer term to lower your monthly payment.

00:03:42 Daniel Hill: You can, but you need to be very careful with this strategy. While it can provide short term cash flow relief, extending your loan term usually means you'll pay significantly more in total interest over the life of the loan. The third and less common goal is to cash out equity, which applies mainly to mortgages. This is where you refinance for more than you currently owe on your home, and you receive the difference in cash. People often do this to pay for a major home renovation or to consolidate high interest debt.

00:04:16 Shanna Browning: All right, so I can get that too. So let's go into specific examples. Right. So let's start with the one from your story the auto loan. This is very common type of refinancing.

00:04:27 Daniel Hill: It is. And it's also a lot simpler and cheaper than refinancing a mortgage. So when is it a good idea to look at refinancing your car loan.

00:04:38 Shanna Browning: Well there's probably two main triggers for that. The first, as we mentioned, is if your if your credit score has improved substantially. So let's say you bought your car when your score was seven hundred twenty and you got a nine percent interest rate. Now two years later, you've made every payment on time. You've paid down some credit card debt and now your credit score is seven forty. Well, you're in a obviously much better position than a credit tier, and you're likely to qualify for a rate closer to four or five percent.

00:05:09 Daniel Hill: And on a twenty thousand dollars loan. That difference in interest can save you a lot of money.

00:05:15 Shanna Browning: A lot of money. And that's always the goal. So the second trigger is if maybe the the market interest rates have fallen, if you bought your car at a time when interest rates were a little higher across the board. But now the fed Federal Reserve Board has lowered rates and lenders are offering better deals. Well, now is a great time to see if you can take advantage of that.

00:05:36 Daniel Hill: Absolutely. And we'll talk about fed rate cuts in future episodes. But what do people need to have ready when they rethink about refinancing?

00:05:46 Shanna Browning: So you're going to need the specifics of what your current loan is right. So what's your current interest rate. What's your remaining loan balance? How many months are left on your loan? Also, you need to make sure that your current loan doesn't have a prepayment penalty.

00:06:02 Daniel Hill: Oh, that is a key detail. Shanna, what is a prepayment penalty?

00:06:08 Shanna Browning: Well, some lenders will charge you a fee if you pay that loan off early, which is exactly what you're doing when you refinance. You're paying off old debt with new debt. So it's less common on auto loans than it used to be. But check your original loan documents or ask your lender if there's a prepayment penalty. You have to do the math to make sure the money you're saving from the lower interest rate is more than the fee you have to pay. Mm.

00:06:36 Daniel Hill: That's good. All right, Shanna, let's talk about the big one refinancing a mortgage. The potential savings here can be life changing, but the process is also more complex and expensive.

00:06:48 Shanna Browning: It really is because you're talking larger amounts. So unlike an auto loan which might have a small application fee. Refinancing a mortgage comes with closing costs, just like when you bought the house, and these costs can include appraisal fees, title insurance, loan origination fee, and they typically amount to two percent to five percent of the new loan amount. So I will tell you, my experience is if you are lowering your payment one percent, it's a good time to refinance a house.

00:07:27 Daniel Hill: That's good. That's that's really good.

00:07:29 Shanna Browning: Because that will cover your closing costs.

00:07:31 Daniel Hill: Yeah, because on a two hundred thousand dollars refinance, you could be looking at closing costs of four to ten thousand dollars. And that's a significant amount of money, right?

00:07:41 Shanna Browning: It's a significant amount of money. And it is. And that's why it's the most important calculation you need to do when considering a mortgage refinance is your break even point.

00:07:52 Daniel Hill: So Shanna, how do you calculate that?

00:07:54 Shanna Browning: Well, it's pretty simple formula. You just take your closing cost and you divide that by your monthly saving, your sorry, your monthly savings from that new lower payment. Right. So for example, if your closing costs are five thousand dollars and your new mortgage payment is two hundred dollars less per month, your break even point is twenty five months. So that's the five thousand divided by the two hundred.

00:08:20 Daniel Hill: So it will take you twenty five months just to recoup the cost of the refinance.

00:08:26 Shanna Browning: Yes it does. That's exactly right. So this means that refinancing only makes sense if you plan to stay in the home for longer than your break even point. If you think you might sell that house in two years. In this example, you're going to lose money by refinancing.

00:08:43 Daniel Hill: What a crucial piece of the puzzle. So what's a good rule of thumb for when to even start looking at a mortgage refinance.

00:08:52 Shanna Browning: Well, a common guideline is what we kind of just talked about. If you can lower your interest rate by at least one full percent point. So the example of that's going to be if your current mortgage rate is at six point two five, sorry, excuse me, six point five percent. And now you see rates are being offered around five point five percent or lower. Well there's your one percent. That's a good signal to start running the numbers and seeing if it makes sense for your situation. Again, keep that break even point in mind.

00:09:23 Daniel Hill: This is such a complex topic, but what a good breakdown of of what to look for, what steps to do. The key is that refinancing is a tool, and you have to do the math to see if it's the right tool for your specific situation. Which brings us to this week's actionable tip.

00:09:46 Shanna Browning: Now listen y'all know we love our action tips for you guys. They take a few minutes but it's important for you. So your action item for this week is for you to become the expert on your biggest loan. Find your paperwork for either your mortgage or your auto loan.

00:10:02 Daniel Hill: Once you've found that your mission is to find and write down three key pieces of information, what is your current interest rate? What is your current remaining balance, and how many months are left on your loan?

00:10:18 Shanna Browning: I mean, let's be honest, just finding this information and having having it handy is a huge step. It gives you the data you need to compare to potentially refinance any kind of offer. And while you're looking at your documents, you got to check for one more thing. See if it has any mention of a prepayment penalty.

00:10:39 Daniel Hill: That prepayment penalty.

00:10:40 Shanna Browning: Yep.

00:10:41 Daniel Hill: Now you don't have to apply for anything this week. Just gather your own data. Knowledge is the first step to making a smart financial decision, and this one simple action will put you in the driver's seat, right?

00:10:57 Shanna Browning: Knowledge is power and it's empowering you with that information. And speaking of information, next week we're going to be talking about a big one you hear in the news quite a bit the fed.

00:11:10 Daniel Hill: We'll explain who they are and what it means for your wallet when they change interest rates. For Shanna Browning and our entire team, I am Daniel Hill. Thanks for listening.

00:11:22 Shanna Browning: And always remember to subscribe so you never miss an episode. Go out and make sense of your cents.