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7 Traps to Avoid When Refinancing a Personal Loan

Refinancing a personal loan typically seems like a great idea when you see that rates have dropped because you think you will save large amounts of money. While you might save some money, there are certain ways that banks can make up for the lower rate, costing you more for the loan in the end. Understanding all of the pitfalls that can occur when refinancing a personal loan will help you determine what the right decision is for you.

1.  Not Reading the Fine Print

The fine print is where lenders put all of the pertinent information. If you do not read it, you could miss things like changing terms at a certain time period; late payment fees; or even prepayment penalties. If you do not know all of the terms, you might be slapped with some unknown fees, putting you in financial distress down the road. For example, you might think you are doing a good thing by paying your loan off early so you can save money, but if there is a prepayment penalty, paying early could cost you dearly.

2.  Automatic Withdrawal Requirements

Some lenders require automatic withdrawal for your payments. In exchange for the agreement to automatically withdraw your payments, you get a lower interest rate. If you were to opt out of the agreement down the road, you might find that your payments increase. For example, some lenders charge a fee for making payments by check or over the phone. Make sure to ask about the payment requirements before taking on the loan to understand what your options are to avoid unnecessary fees.

3.  Purchasing Insurance

Many lenders will try to scare you into purchasing life or unemployment insurance in the event that something was to happen to you or your job. They lay it on thick, letting you know that if you become incapable of taking care of the loan, your loved ones will be left with your debt in the case of your death or if you lose your job and are unable to pay the loan, your credit score is at risk. Typically, these insurance policies are expensive and not nearly as effective as insurance policies sold separately from any type of loan.

4.  Falling for Pre-Compute Interest

Most personal loans accrue interest on a weekly, monthly, or annual basis, depending on the terms of the loan. If the interest is pre-computed, it means that the interest over the life of the loan is calculated and automatically added to the balance of the loan. This means that you pay the interest, no matter if you pay the loan off in two months or wait until the end of the term of the loan. If you have the option to pay the loan off early and not have interest calculated on that amount, you could save large amounts of money.

5.  Not Comparing the APR

It is easy to get caught up in the interest rate you are being charged on your personal loan, focusing solely on that factor when shopping around. What you might not realize, however, is that even the lowest interest rate could cost you more in the long run if there are large fees the lender charges, such as an origination fee.  When you compare the APR, you are evaluating the full cost of the loan over the life of the payments, rather than just the rate you are being quoted on the loan. Remember, the lender has to make money somewhere, so you need to be a detective in figuring out what they are actually charging you.

6.  Stretching Out the Term

Refinancing a personal loan might seem smart because your payment will decrease, but if you are extending the term of the loan much longer than you had left, you are paying more interest in the long run. Lenders will try to convince you to take as long of a term as possible because the longer it takes you to pay the loan off, the more interest you pay. This does not make sense financially for you, especially if you have already made a decent amount of payments towards the debt. Calculate the full cost of the new loan to determine if it is the right choice for you.

6.  Borrowing More Money

Refinancing your loan sometimes means you can take a larger amount out, especially if you have a good chunk already paid off. If you do this, however, similar to stretching out the term, you are increasing how much you owe. Even if the interest rate decreases, you are paying more money back, negating the benefits of refinancing in the first place.

Refinancing your personal loan does make sense in many cases, but taking the time to do your due diligence to ensure that you do not overpay for the loan or pay fines that you did not know existed will keep you safe. There are many lenders to shop around with, so make sure you take your time and see what other lenders offer before you jump headfirst into a loan.