Before we can begin the conversation, let’s first make sure we understand what the term “re-financing” actually means. The following is a common scenario: Mary took a personal loan from the bank for $15,000 with an interest rate of 3% for a 5-year term. After 3 years, Mary decides that she would like more funds in her account and elects to visit her bank to see what options she has. “Well,” says the banker, “I have great news for you, Mary! You qualify to re-finance your loan with us and not only that, I can reduce your interest rate from 3% down to 2.5%! Instead of your original $15,000, we can increase your loan to $25,000. Is this something you are interested in?” Give this question a minute of thought and see if you can come up with good advice for Mary.
The above scenario is something that we are faced with all the time whether it be a bank loan, a car loan, an installment loan, etc. The offer can come in variations such as when you have a car loan and the bank now offers you a line-of-credit as a re-financing option. Yes, banks do claim to “have you in their best interest and ONLY want what’s best for you (duh),” but let’s be real here. Are you saving money or are they earning more by these offers? Before making any decisions about whether-or-not you should accept their offer, understand what it means to re-finance and then you will be better equipped to make these important financial decisions.
Whenever you are currently paying on a loan, different lenders will have several ways of setting up payment distributions to determine where funds are applied. Depending on how the distribution is applied will heavily impact your decision to re-finance or not. The following is a list of different options that exist for payment distributions. The term Amortization is an accounting term that refers to the process of allocating the cost of an intangible asset over a given period of time. Or, in our discussion, refers to the repayment of loan principle over time.
Option 1) Amortization: this is when the payment distribution applies a larger percentage to principle in the first half of the term and more to interest in the second half. Although the term Amortization has implications in different kinds of payment distributions, in lay terms it refers to payments that weigh principle first and the interest later on.
Option 2) Fixed Principle and Fixed Interest: In this payment distribution, all payments are applied the same throughout your term period with a fixed amount going towards principle and a fixed amount going towards interest. This does not mean that 50% of your payments are being applied to principle but rather, that the same percentage that is applied to principle holds true for every payment. As payments are received, your loan balance continues to drop.
Option 3) Rule of 78: Here, the concept is similar to that of an amortized schedule (as noted in option 1) but is reversed in payment attribution. In this scenario, the majority of payments are being applied to interest at the beginning with principle attribution towards the end of the loan term.
What does this have to do with re-financing you ask? Great question! You see, depending on the payment attributions of your existing loan not only impact the overall cost of borrowing but will help you decide whether or not it makes sense to refinance your current balance. Depending on which option your lender offers and based on the current remaining balance of your loan, you can then determine if re-financing is in your best financial interest (pardon the pun). Prior to making any such decisions, find out what your distribution is and determine if that interest rate deduction is in your best interest.
Let’s get back to Mary from above. It turns out that her current payment distribution was option 2, where payments were applied as a fixed interest and fixed principal. In this case, it doesn’t matter where she was standing in her current loan term as each payment was applied with the same percentage going towards principle and interest. Therefore, it would not harm Mary if she decides to re-finance because her principle balance is reduced by each payment equally. Furthermore, if she is being offered a 0.5% reduction in interest rates, it would actually benefit her to take this option as she will be saving on her current cost of borrowing. So, before making any rash decisions, understand more about your loan and how your payments chip away at your balance!
By Gregory O’Connor, financial advisor