Should You Refinance Your Installment Loan? 4 Factors to Consider

We write a lot about borrowing here on the OppU Blog. We write about how folks with bad credit should avoid payday loans, and how people can go about borrowing money from friends and family members.

However, there’s one aspect of borrowing that we don’t write about so much: refinancing. Refinancing is a really important part of borrowing. If you have an installment loan, whether it's a traditional unsecured personal loan, auto loan, bad credit loan, etc., here are four factors you should keep in mind when considering whether or not to refinance (for more information, read What Is An Installment Loan? ).

1. Do you need it?

This might seem obvious, but it never hurts to go over the basic building blocks of responsible financial behavior.

When a person is refinancing their loan, they are usually doing one of two things: borrowing more money or borrowing the same amount of money with new payment terms and a new interest rate.

If you’re refinancing an installment loan in order to take out more money, you first need to have an honest conversation with yourself about why you’re doing it; is it to pay for a “want” purchase, or is this a very important “need” like an unexpected car repair?

If it is for a “want” purchase, then you probably should not refinance. Instead, take a look at your budget and see where you can cut back in order to make the purchase without credit. If you don’t have a budget, then you should consider starting one.

If you’re refinancing your loan in order to pay for a “need,” then it may be a sound idea. However, it wouldn’t hurt to review your finances and see if you can cover the bill without borrowing. Refinancing means more payments and more interest. Make sure it is your best financial option before you commit to it.

2. The size of your payments.

If you are refinancing for the same loan amount at a longer term and/or with a better interest rate, you should take a look at what your new payments will be.

Here’s the good news: They will probably be smaller! The same amount of money stretched over a longer period of time will mean less money put towards each individual payment.

Take this exercise a step further: what will you do with the extra room that you create in your monthly budget? Look at what you can do with the extra funds. Consider using them to build an emergency fund or to bolster the emergency fund that you already have. You could also automatically deposit them in a retirement account where they will grow and earn interest.

Remember: smaller payments are great, but more payments overall still means paying extra money towards interest. Is that extra room in your budget worth the additional costs? Calculate the total amount you will pay in interest to understand the overall effect that refinancing would have on your financial wellbeing.

3. Interest rates.

The one thing you should never do is refinance a loan at a higher interest rate. That doesn’t make sense. If you refinance at a higher rate it’s probably because you made a big financial misstep elsewhere that you are now scrambling to correct.

Now, if you are refinancing at a lower rate, congratulations! You're clearly doing something right. However, just because you are offered a lower rate doesn’t mean you should take it. As we discussed, a longer repayment term likely means paying more interest charges overall, even if you get a lower rate!

Our advice here is the same: do the math and weigh the benefits. If you end up paying less money in interest overall, that’s one thing. However, paying interest for a longer period of time means that you need to weigh the benefits of lower rates and smaller individual payments. The more productive you can be with the extra money you save, the better.

4. Your credit score.

If you want to steer clear of bad credit loans you will need good credit!

If your lender reports to the credit bureaus, then every payment that you make on your installment loan is recorded on your credit report. That's important, because your payment history is the single largest factor in determining your FICO score, making up 35% of the total. This means that any on-time payments you make on your bad credit installment loan may improve your credit score!

This alone is not reason enough to refinance your loan. However, if each additional payment you make translates to a positive mark on your credit report, you could graduate to more affordable loans and credit cards in the future if your score improves enough. At the very least, it's something to consider seriously.

In the end, whether or not you should refinance your installment loan depends on your individual financial situation. Take these four factors into account, triple-check your math, and make the most informed decision possible.