Effective debt refinancing can help you to save thousands of dollars in interest expenses each year. To save money, you may consider debt refinancing. To improve your chances of refinancing debt on good terms, you must learn to both strengthen your own financial positioning and monitor Federal Reserve interest rate policy. In all cases, you will weigh the up-front costs of refinancing against the long-term benefits of interest savings before making a final debt management decision.
Identification
Debt refinancing describes a series of transactions where you take out a new loan and use the cash proceeds to pay off existing debt. With refinancing, the ultimate goal is to effectively secure a lower interest rate on your overall debt. In some cases, you will refinance a variable-rate loan into a fixed-rate loan to reduce financial risks. A variable-rate loan features interest rates that shift alongside the economy, while a fixed-rate loan charges a level interest rate throughout its term. When interest rates rise, payments on a variable-rate loan may then become unaffordable.
Federal Reserve
The Federal Reserve manages the prevailing interest rate environment through its federal funds rate. The federal funds rate serves as a benchmark, or comparison standard, for all other interest rates. Banks make overnight loans to each other at the federal funds rate, so that each financial institution can meet its Federal Reserve requirements. In turn, banks charge premium rates above the federal funds rate when making out loans to private individuals and businesses, as compensation for the increased default risks. Your chances for refinancing debt at a good rate do improve amid recession. In recession, the Federal Reserve coordinates interest rate cuts to encourage people to take out loans and purchase goods, which improves the economy.
Personal Finances
You will evaluate the strength of your personal finances before applying for a new loan to refinance debt. Before submitting any loan application, you should work to make timely payments on all bills and also prove that you can maintain at least six months worth of living expenses in cash reserves. To monitor your debt management history, you should order a free credit report from Experian, TransUnion or Equifax (see Resources). If your report shows wrong information, you may file an online dispute with the appropriate agency.
Refinancing Costs
For larger loans, you will incur significant costs throughout the application process. According to the Federal Reserve Board, you may pay closing costs worth 3 percent of your home loan principal when refinancing a mortgage. Closing costs pay the bank to process your application, appraise the value of your home and hire lawyers to verify title records.
Strategy
You can use an online financial calculator and toggle through estimates to determine whether future interest savings can make up for the up-front costs of refinancing (see Resources). For a mortgage refinancing, the deal should be attractive if you can reduce your home loan rate by more than 1 percent and plan to own the home for at least the next 10 years.
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