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What Does it Mean to “Refinance”?

Re-financing is often a term you hear adults using in regard to their mortgage, car, or other assets. Let’s take a look at what re-financing means.

When you take a loan out on your house or car, you are borrowing money from one institution to pay another. For example, let’s say you want to buy a car for $20,000. You are probably like most other individuals and unfortunately did not hit the billion-dollar lottery. Therefore, you don’t have $20,000 immediately available sitting in your purse or bank account. You decide to take out a car loan from a bank so that you can still purchase this car. When you take out the loan, the bank is essentially giving you the $20,000 up front and you will pay the bank back over time. This is how a lot of banks make money. They provide you a certain amount of money and you repay them back the amount borrowed, and then some (the interest), over a specified period of time.

Let’s say for our example that you took out this car loan with a 5% interest rate. This means that you will pay the $20,000 and 5% interest back to the bank. This would mean you pay about $296.00 per month for 72 months.

Fast forward 12 months, you are still paying $296.00 each and every month and doing well. However, you see that your bank is now offering a car loan with a 2% interest rate. That is a better rate than you have now and one you wish you could have received last year when the car was purchased. It’s too bad you’re out of luck because you already have your loan, right? Wrong. You can re-finance. This simply means that you open a new loan, with the purpose of paying off your existing loan. Since you have already been paying down your existing loan, you should only have about $16,448 of the initial $20,000 to pay. Therefore, you can apply to get a new loan from the bank (with the lower interest rate of 2%) and basically swap loans. Remember, a loan is an advance of money. To pay off the original loan (which had the 5% interest rate), the bank will loan you the amount needed to pay off the existing loan with the original institution. Now that the new bank has given you a loan, you will pay them back over time, but the key is that the payments will be less overall due to the lower interest that must be paid back. This will save you money in the long run as you will only be paying about $216.00 per month—a savings of about $80 per month.

The general concept is that a new loan is taken out to immediately pay off the old loan. The bank would loan you the remaining amount of money you need in order to completely pay off the original loan with them. Once this first loan is closed and paid in full, the new loan is what needs to be paid going forward. The benefit of this process is that now the loan with a 5% interest rate is closed. You will still be paying interest to the bank for the new loan but it will be less money in the long run. With the new interest rate of 2%, it would mean payments of $216.00 per month---a savings of about $80 per month!

Now you can see why so many people are discussing re-financing options—it can save a lot of money!!

*Refinancing might not always be in your best interest. Be sure to understand the length of the loan, the interest rate, and other factors to make sure it is saving you money and not costing you in the long run.

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