When a consumer refinances a loan, he allows a lender to pay off an existing loan in exchange for a new one that may have a different interest rate, a different duration or other differences from the original loan. For example, if you owe $100,000 on a mortgage to a local bank with a 5 percent interest rate, a different local bank might be willing to pay off your debt obligation and offer you a $100,000 mortgage with a 4.5 percent interest rate.
Refinancing can allow borrowers to capitalize on low interest rates. If, for instance, interest rates were 8 percent when you purchased a home and they fall to 5 percent, you might save a significant amount of money by refinancing your mortgage to capture the 5 percent rate. Refinancing can also allow you to switch from a variable interest rate to a fixed rate or increase the duration of a loan to reduce the size of monthly payments.
The primary disadvantage of refinancing is that you may incur a number of fees that will offset savings gained from lower interest rates. According to the U.S. Federal Reserve Board, refinancing may include application fees, appraisal fees, inspection fees, attorney fees and other costs which can amount to over 5 percent the value of a loan. Since fees are paid up front, it can take several years for savings exceed costs.
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Since refinancing can be a costly process, it is important to calculate the savings you will realize from lowering your interest rate ahead of time. If the interest rate you can gain from refinancing not much less than your current rate, you may not stand to save money by refinancing. The U.S. Federal Reserve Board recommends that borrowers compare several different loans before refinancing to find the best deal.