Should You Refinance Your Installment Loan? 4 Factors to Consider

We write a lot about borrowing here on the TheLending Blog. We write about how folks with bad credit should avoid payday loans, about how people can go about borrowing money from friends and family members, and how one can responsibly maximize purchase rewards without racking up excess debt.

But there’s one aspect of borrowing that we don’t write about so much: refinancing. This post is an attempt to rectify that because refinancing is a really important part of borrowing! So if you have an installment loan—whether it's a traditional unsecured personal loan, an auto loan, a bad credit loan, etc.—here are four factors you should keep in mind when considering whether or not to refinance. (For all the details on installment loans, check out the TheLending Guide to Installment Loans here.)

1. Do you need it?

This might seem pretty basic, 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: They are either borrowing more money or they are borrowing the same amount of money with new payment terms and a new interest rate. This factor generally applies to the former.

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

If it’s for a “want” purchase, then you probably shouldn’t refinance. Instead, take a look at your budget and see where you can cut back in order to make the purchase without credit. And if you don’t have a budget, then you should definitely start one!

Now, if you’re refinancing your loan in order to pay for a “need,” then you’re on much more solid ground. Still, it wouldn’t hurt to take a look at your finances and see if you can cover that bill without borrowing. Refinancing means more payments (which can have their benefits) and more interest (which doesn’t). Make sure it’s your best financial option before committing.

2. The size of your payments.

Now, if you are refinancing for the same loan amount, just at a longer term and/or with a better interest, you should take a look at what your new payments are going to look like.

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

Take this exercise a step further: What are you going to be doing with the extra room that you’re creating in your monthly budget? Is this money that you’re going to just be spending? Because that’s probably not the best use for it!

Look at what you can do with those extra funds. Consider using them to build an emergency fund or to bolster the emergency fund that you already have. You could also have them automatically deposited in a retirement account, where they will grow and earn interest.

And remember: Smaller payments are great, but more payments overall still mean paying extra money towards interest. Is that extra room in your budget worth those additional costs? Calculate the total amount you’ll be paying in interest to help you weigh the overall effect that refinancing would have on your financial wellbeing.

3. Interest rates.

The one thing you should never be doing is refinancing a loan at a higher interest rate than what you were paying previously. That just doesn’t make any sense. If you find yourself needing to 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. Still, just because you’re being offered a lower rate doesn’t mean you should take it. Similar to what we discussed in the previous section, that longer payment term likely means paying more in interest charges overall—even if you're getting a lower rate!

Our advice here is the same as it was up above: Do the math and weigh the benefits. If you end up paying less money in interest overall, that’s one thing. But paying interest for a longer period of time means that you need to weigh the benefits of those lower rates and smaller individual payments. Still, the more productive you can be with that extra money you're saving, the better.

4. Your credit score.

If your lender reports to the credit bureaus, then every payment that you make on your installment loan gets recorded on your credit report. That's important, because your payment history is actually 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 are actually helping your score!

Now, this isn’t really a good enough reason on its own to refinance your loan. However, it's not for nothing if each additional payment you make translates to another positive mark on your credit report. If your score improves enough, you could even graduate to more affordable loans and credit cards in the future! At the very least, it's something to seriously consider.

In the end, whether or not you should refinance your installment loan is going to come down to your individual financial situation. The best you can do is take all these factors into account, triple-check all your math, and make the most informed decision possible.

Want to steer clear of bad credit loans? Well, you're going to need good credit!