Should You Refinance Loans When Interest Rates are Rising?
Refinancing is a strategy that many borrowers use to reduce the interest paid on loans and to make monthly payments more manageable.
But, when interest rates are rising, new loans can be more expensive. You might be hesitant to refinance your debt when the interest-rate environment doesn't encourage borrowing.
However, there are times when it can still make sense to do so.
What is a Variable Interest Rate?
Put simply, a variable interest rate is an interest rate that changes over time.
With a fixed-rate loan, you’ll know exactly how much interest you’ll be charged over the loan’s life.
Variable-rate loans have constantly changing interest rates.
You can’t predict what your interest rate will be a year from now, which means you can’t know how much your loan will cost in total.
Interest rates change over time in response to the economy.
The Federal Reserve sets target interest rates based on multiple economic indicators.
Roughly speaking, when the economy is poor, rates go down. Lower interest rates encourage more spending, which gives the economy a boost.
When the economy is good, rates go up as saving becomes easier.
Variable-rate credit lines
Many credit lines have variable interest rates. One of the most common credit lines to carry a variable interest rate is the credit card.
Usually, when you have the option to choose a fixed rate loan or a variable rate loan, the variable rate loan’s rate starts off somewhat lower.
If rates hold steady or go down, you benefit, but if rates rise, you could wind up paying much more than you expect.
Federal funds rate
Variable-rate loans usually rely on a benchmark rate, such as the Federal Funds rate, to determine their current rate.
For example, you might get a loan with an interest rate equal to the Federal Funds rate plus 1%.
If the Federal Funds rate increases, your loan’s interest rate will increase.
If the Federal Funds rate goes down, so will your interest rate.
The Federal Funds rate isn’t actually directly set by the Federal Reserve. Instead, the Federal Reserve sets a target rate and uses other tools to reach that target.
It is the rate at which banks make overnight loans to each other. As the economy improves and banks want to lend to consumers, they have less to lend to each other, increasing rates.
When fewer consumers are borrowing, banks will have more money to lend to each other, driving the Federal Funds rate down.
The effect of this is that your interest rate will change as the economy changes.
You could wind up paying less or more as the Federal Funds rate changes.
The danger is that a huge increase in rates could leave you with a monthly payment you cannot handle.
What is Refinancing?
Refinancing a loan gives you the opportunity to change the terms of a loan you’ve already taken on.
Usually, once you sign a loan contract, the terms are fixed and cannot be changed. When you refinance a loan, what you’re really doing is taking out a brand new loan and using the money to pay off an existing loan or loans.
That lets you exchange the terms of your old loan for a new one.
Changing the terms of a loan can be beneficial for a number of reasons.
You can reduce the size of your monthly payments or give yourself more time to pay the loan off. You can also exchange a fixed rate loan for a variable rate loan, or vice versa.
Usually, you want to refinance when you can get a better deal on a new loan than you got originally.
When rates are rising, it makes less sense to refinance because you’ll wind up paying more because your new loan will have a higher rate. The time when it may make sense to refinance when rates are rising is if you have a variable rate loan and fear that rates will rise further.
When Refinancing Might Make Sense
There are a few situations in which refinancing your loan could be a good idea.
When the new APR is still lower than your current APR
The clearest scenario in which you should refinance a loan is when you can reduce your loan’s APR. This is especially true if your new loan will have a fixed interest rate, allowing you to lock in the savings permanently.
If you can refinance to a loan with the same term, you will pay less interest over the life of the loan and reduce your monthly payments. This can give you more freedom to spend money month-to-month and means you’ll waste less on in total.
The only thing to watch out for is that you will often have to pay fees when you refinance a loan. Whether it be an origination fee, balance transfer fee, or some other fee, refinancing is rarely free.
Make sure that the savings you get from reducing your loan’s APR exceed the cost of refinancing.
You want to reduce your monthly payment
Peoples’ financial situations change all the time. A monthly payment that you may have been able to handle when you applied for the loan might become unmanageable for a number of reasons.
You might lose your job, encounter an unexpected expense, or have some other need for money leaving you unable to make payments.
Refinancing your loan will allow you to extend the term of your loan. For example, if you have a loan with three years left on the payment schedule, you can refinance to a five-year loan.
This will reduce your monthly payment significantly, but means you’ll have to take two extra years to pay the loan off.
The biggest downside of this is that you’ll pay more interest because you’ll be carrying the loan for a longer time.
You want to remove a co-signer from a loan
If you have poor or no credit but need a loan you’re likely to have trouble qualifying for a loan. That’s where a co-signer comes in.
Co-signers vouch for your trustworthiness, which can help you qualify for a loan.
If someone with good credit tells a lender that you’re a good lending risk, the lender will be more likely to offer you a loan.
Co-signers also agree to put their money where their mouth is when they co-sign on your loan. If you fail to make your required monthly payments, your co-signer becomes liable for your debt. This is a big commitment for a co-signer because they could wind up responsible for thousands in debt without getting any of the benefits of borrowing that money.
If you get a loan by having a co-signer and make your payments in a timely manner, your credit should improve over time.
Eventually, your credit score will be good enough that you can qualify for a loan on your own merit.
Because co-signers take on so much responsibility by co-signing on your loan, you might want to get them removed from your loan when a co-signer is no longer necessary.
Refinancing is the best way to get a co-signer removed from a loan. If you no longer want someone to be a co-signer, refinance, but be aware of the interest rate and fees that will apply to your new loan.
You want to free up collateral
Another strategy for people who have poor credit is to apply for a secured loan.
Many loans are unsecured loans, where you receive money and provide only your word that you’ll pay the money back.
A secured loan requires that you put down some collateral.
For example, you might put money into a certificate of deposit (CD) and use the CD as collateral for a loan.
Having collateral reduces the risk for lenders because they can simply take possession of the collateral if you stop making payments. That makes lenders more willing to lend you money if you provide collateral.
Of course, the downside for you is that you must have something of value to provide as collateral. You could wind up having hundreds or thousands of dollars tied up in securing your loans.
Once you’ve had your loan for long enough, your credit score should have improved. You can then try to refinance to an unsecured loan.
When the secured loan is paid off with your new unsecured loan, your collateral will be returned to you.
Don’t forget that refinancing will result in a new interest rate and fees, so make sure the change in rate is worth getting your collateral back.
There are many situations where refinancing can make sense, but it’s difficult to justify in an environment where rates are rising.
Look to refinance when you can reduce the rate of your loan or if you need to reduce your monthly payment because of a change in your financial situation.