Refinancing is sometimes pitched as if it were a miracle cure for debt woes. But while refinancing can lower your interest rate and make your obligations more manageable, the FDIC recently reminded consumers that refinancing can also turn into a costly mistake in the long run.
Mortgage refinancing is the most widely known form of refinancing, but you can also refinance credit card debt, car loans and even student loan debt. The question is, should you? 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."
The downsides of new loans
Here are some of the potential costs noted in the FDIC newsletter and how they can work against your money-saving efforts.
- Hidden long-term costs. 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.
- Impact on your credit score. 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 shifting balances around leads you to opening and closing 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 around in the first place.
- Different interest tiers. Another hazard of balance transfer offers is that those credit 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.
- More years of interest. When it comes to loans, 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 will 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. They may negate the benefit of lowering your interest rate, but they may be avoidable if you wait a little longer to refinance.
- Transfer fees. The catch behind many zero percent balance transfer 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. If you refinance a government-backed student loan with one from a private lender, you may lose certain government benefits, such as income-based payment options.
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 opt for a new loan.