Are you dealing with student loans? A home mortgage? An auto loan? Credit cards? Oh my!
If you are dealing with debt, chances are refinance offers have appealed to you. Whether it is to refinance your student loans for a possible savings of $280 per month, to refinance your home mortgage for a lower APR, or to refinance your credit card debt for 1% or even 0% APR, refinancing is an appealing option to many of us.
How many times have you asked the question: Why are they so eager to get my business? Why are they so willing to charge me a lower rate if I move my loans to them?
The answer is often times because they win. Lenders compete on the refinance market just as ruthlessly as they compete to originate loans. To them, the secondary market can be just as profitable. All they have to do to win your business, is undercut their competitors by a fraction of a percent.
Unfortunately, refinancing does not always work out well for the consumer. Usually, consumers accept refinancing deals for one reason: a lower payment. If a lender can offer a lower rate, that is often enough incentive to gain the average consumers business. However, as Dave Ramsey points out, the average consumer is broke. And that lower payment does not really make things better; it just kicks the can down the road.
Longer Loan Terms
The real reason why the typical refinance results in a lower monthly payment is not because the interest rate is reduced. All things considered, interest rates are highly level and lenders cannot compete solely on interest rates.
A fraction of a percent change is hardly enough to tip the scales one way or another, especially if there are closing costs and transactional costs.
The real reason why the typical refinance results in a lower monthly payment is because the loan term is extended.
Let’s take for example John Smith who had a $40,000 student loan debt. The student loan was on a standard 10 year repayment term with an APR of 6.200%, and a monthly payment of $448.11.
John had been paying on his student loans for a while, and now has 3 years remaining. John accepted a refinance offer which brought his APR down to 3.875%, and his payment down to $194.83. Whoa! Sounds like a great deal!
The problem is in order for that low APR and payment to work, the loan would be extended for an additional 4 years. By taking the refinance, not only will John be in debt for an additional 4 years (above and beyond the original student loan term), but he will pay an additional $724.64 in interest.
Longer Loan Terms = More Interest
In most cases, longer loan terms result in more interest. Not always, but in most cases.
If your refinance will give you a lower monthly payment, that is great. However, it is important to look at the whole puzzle and not just one piece. A lower monthly payment is not worth it if it means more interest and more time in debt. It is important to look at how much total, not simply how much per month.
The purpose of this post is not to scare you. And it certainly is not to incriminate any refinance offer as being bad.
The purpose of this post is to show how a typical refinance can be a bad deal in the long run. The John Smith example above used REAL loan terms. Only the name of the person was changed, in order to protect the innocent.
Refinancing can be a great tool. A refinance can be an advantage and can help us pay off debts quicker and easier. However, we cannot be disillusioned into thinking that all widely advertised refinances are great deals. We cannot be disillusioned into thinking that refinancing with a reputable company is always a good deal. We cannot be disillusioned into thinking that refinancing with a smaller, less known, company is always bad.
At the end of the day, it comes down to math. No lender and no type of refinance is immune to the laws of math. The devil is always in the details, and the details are rarely explained.