The COVID-19 crisis brought about a significant change in the way people handle their finances. Below are some numbers recently reported by Forbes:
- Personal loan debt growth had slowed by 6%, primarily owing to lenders being hesitant to offer loans as millions were losing jobs left and right.
- The average borrower’s loan debt was almost the same in 2020 as in 2019, though loan accounts have increased by a modest 8%.
- Average loan sizes dropped by almost USD$ 1,200, from USD$ 6,012 in January 2020 to USD$ 4,815 by yearend.
- Debt consolidation and refinancing accounted for over 60% of loan applications, as it had been before the pandemic hit hard.
The last item is quite interesting. Regardless of the state of the world, everyone still has to deal with financial problems, big or small. Consolidation and refinancing provide financial relief to an extent, either by combining loans into one or replacing a loan with a more manageable one.
But remember to tread lightly, especially with refinancing. While refinancing itself will result in a credit score drop, ignoring the following tips can drag it dangerously low.
1. Making sure it’s the best option
The first of these tips is perhaps the most crucial: asking yourself if refinancing is right for you. As the term implies, it involves applying for another loan in hopes of reducing interest rates and, ultimately, monthly dues.
Since you’re taking out a new loan to replace the one you can’t manage, lenders will be more cautious. Their reduced confidence in your ability to pay will result in a temporary drop in credit score. Fortunately, a hard inquiry on the lender’s part will only cost you five points at most. The deduction is naturally lower for people with a strong credit history.
The reduced payments from a refinanced loan may be a blessing, but the borrower will start all over. There’s the risk that they can end up paying more in interest and nullify any savings they would’ve made by refinancing–and it doesn’t just stop there.
2. Lowering interest considerably
As mentioned, one of the purposes of refinancing is to negotiate a lower interest rate. A rule of thumb in the industry is that refinancing is best if borrowers can get their interest rate to drop by at least 2%, though some say 1% is already sufficient. Studying market movements via specialized sites like EducationData.org and others can help determine how viable refinancing is for you. (2)
Supposed you’re currently paying back a USD$ 100,000 mortgage loan with a 5% interest rate for 30 years. This loan has you paying USD$ 536.82 every month. When a refinance gets the same loan but with a 3% interest rate, the premium drops to USD$ 421.60. The amount in interest paid also falls from USD$ 93,256 in the 5% to USD$ 51,778 in the 3%.
However, you can only take advantage of this if the refinanced loan has a variable interest rate–and even that has its risks. If interest rates in the market move against your favor, the refinanced loan may do more harm than good. Also, not all lenders offer loans with variable interest.
3. Spreading payments over a longer period
Aside from lowering interest rates, refinancing can also lengthen the loan period. Going back to the example from earlier, a USD$ 100,000 mortgage loan with a 5% interest rate can have you paying USD$ 790.79 in premiums over 15 years but just USD$ 536.82 if increased to 30 years.
Then again, anyone thinking about letting their loans run for longer should choose if they want to pay less now or build home equity later. Paying a reduced premium comes with the ever-painful sting of increased interest paid. You might not feel it, but you’ll eventually realize that what you paid in interest could’ve been spent on more important things. (3)
On the other hand, a higher premium will save you on interest and result in other benefits, such as increasing home equity. The higher home equity gets, the more dispensable finances you have for any unexpected expenses. However, be careful in using home equity, as failing to sustain it can damage your credit score. (3)
4. The Debt-To-Income (DTI) ratio
The DTI ratio is an essential metric that lenders use to determine a borrower’s ability to pay. The formula is as simple as dividing the borrower’s total monthly debt dues with their gross monthly income. The higher the DTI, the less able a borrower will be able to sustain a loan.
But how high should it get before a borrower becomes too much of a risk? The lending threshold sits at 43% (those with higher DTI ratios can still qualify for loans under special cases), meaning no more than 43% of their monthly gross income should go to their debts. Many experts advise keeping the ratio at around 36% to secure decent loan terms. (4)
Refinancing is still possible with a high DTI ratio, but it’ll be harder to secure. In most situations, lenders will recommend their clients to pay off their outstanding debts or increase their income by any means. Only when the ratio stabilizes beneath the recommended threshold can lenders be more willing to talk loans.
5. Doing your homework
If–despite everything explained up to now–you decide to refinance, the least you can do is pick the right lending institution. Due diligence is necessary at the initial phases, finding out whether or not the lender’s features fit the bill. Not doing so might result in a lot of regrets.
Look at business news websites, read financial blogs, inquire with the lenders, ask a friend–do anything to steer clear of a potential pitfall. Otherwise, you might end up with a refinance loan that’s too much to bear. Your credit score will suffer dearly for it.
Conclusion
Overall, refinancing isn’t an option for everyone; it carries as many risks as it does benefits. Take time to understand your financial situation and determine if refinancing is the best option. If it is, take these tips to heart to prevent your credit from degrading.
Sources:
- “Personal Loan Debt Statistics During The Pandemic,” https://www.forbes.com/advisor/personal-loans/personal-loan-debt-statistics-during-the-pandemic/
- “When to Refinance Your Mortgage,” https://www.investopedia.com/mortgage/refinance/when-and-when-not-to-refinance-mortgage/
- “Refinancing Your Mortgage: Understanding the Advantages and Risks,” https://time.com/nextadvisor/mortgages/refinance/risks-and-benefits-of-refinancing-your-mortgage/
- “Debt-to-Income (DTI) Ratio” https://www.investopedia.com/terms/d/dti.asp