Refinancing is sometimes pitched as a miracle cure for debt woes. While refinancing can lower your interest rate and make your obligations more manageable, the Federal Deposit Insurance Corporation (FDIC) reminds consumers that debt refinancing loans can also turn into a costly mistake in the long-run.
Mortgage refinancing is the most widely known refinance type, but credit card debt refinancing, car loan and even student loan debt can all be refinanced. The question is, should you refinance personal debt? That answer depends on how the benefits compare with the potential pitfalls.
"Refinancing a personal loan may save you money, especially if you get a lower interest rate, a lower monthly payment or other benefits," said Susan Boenau, chief of the FDIC's Consumer Affairs Section, in the FDIC's written statement. "However, refinancing does not always equate to saving money or better terms."
Risks with debt refinancing loans
Why would you refinance a loan? There can certainly be benefits in goals related to saving on interest cost and perhaps paying off debt more rapidly. But there are some potential costs noted by FDIC that should be considered:
- Hidden credit card debt refinancing cost. Sometimes the perceived benefits of refinancing are only temporary. For example, zero percent balance transfer offers on credit cards may temporarily reduce your interest, but since those offers only last a limited time, you need to be careful that you do not end up paying a higher rate in the long run.
- Credit score impact. Speaking of credit cards, you need to take care in how you manage the opening and closing of accounts. Opening too many new accounts could weaken your credit score, as could closing an old account on which you have established a reliable payment history. If credit card debt refinancing causes you to shift balances around, leading you to open and close accounts in such a way that it lowers your credit score, then you could end up paying a higher interest rate. That could defeat the purpose of shifting balances in the first place.
- Different interest tiers. Another hazard of credit card balance transfer offers is that those cards often charge a different rate for new purchases than for transferred balances. If you make only partial payments toward your balance, the credit card company has discretion over whether to apply that against new purchases or an existing balance, and they are likely to apply your payments against lower-interest debt first.
- Debt refinancing loans: more years of interest? When you want to refinance personal debt, an easy way to lower your monthly payment is to spread the remaining loan balance over more years. Before you do this though, look at an amortization schedule to see the impact a longer loan could have on the total interest you pay. This strategy can prove expensive over time.
- Prepayment penalties. Before you refinance any loan, be sure to check the prepayment penalties on your existing loan. Why would you refinance a loan if the prepayment penalty negates the benefit of lowering your interest rate? Find out if any prepayment penalty can be avoided if you wait a little longer to refinance personal debt.
- Transfer fees. The catch behind many zero percent balance transfer credit card debt reninancing offers is that there is an upfront fee for making the transfer. Be sure you check for this and factor it into your cost/benefit calculation.
- Loss of federal student loan benefits. Those with student debt sometimes wonder "Should I refinance student loans?" Consider that if you refinance a government-backed student loan with a personal loan from a private lender, you may lose certain government benefits, such as income-based payment options. Determining is it worth it to refinance a student loan must factor in how confident you feel about your job security and income stream.
Remember, financial tactics like refinancing are neither good nor bad -- their value comes down to the numbers. So make sure you have looked at those numbers from every angle before you refinance personal debt.
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