How refinancing works

Resources · Home loans and saving · 5 min read Advanced

Key points

• Refinancing means replacing your current loan with a new one, often at a different rate or term.
• Switching has costs, so a lower rate takes time to pay for itself.
• Restarting a long term can lower repayments but raise the total interest you pay.
• Comparing total cost, not just the repayment, shows the full picture.

How refinancing works, in plain terms

Here’s how refinancing works. You take out a new loan to pay off the one you’ve got. The new loan clears the old balance, and from then on you repay the new loan on its own terms. You’ll hear about it most with home loans, but the same idea applies to car and personal loans.

Why do people do it? Usually for a lower interest rate. Sometimes for a different loan length, a move between fixed and variable, or a feature the old loan never had. Our guide to fixed and variable rates covers that particular choice.

The costs of switching

Refinancing is rarely free, so any honest look at it starts with the costs. The names change from country to country and loan to loan, but the usual suspects look like this.

Depending on the loan and where you live, there may be an application or establishment fee to set up the new loan, plus a discharge or exit fee to close the old one. If the property has to be valued again, there may be a valuation fee. Transferring the mortgage can also bring legal and government registration fees, sometimes grouped together as “closing costs”.

Two more can sting. Leaving a fixed-rate loan before the fixed period ends can trigger break costs on some loans, and these can be large. Check your own loan’s terms. And in some countries you may need mortgage insurance if your deposit or equity sits below a set share of the property’s value.

Some of these can be added to the new loan instead of paid upfront. That spreads them out. It also means you pay interest on them.

A worked example: the break-even point

Assumptions:

• Balance: $350,000
• Time left on the current loan: 25 years
• Current rate: 6.5% a year, charged monthly
• New rate: 6.0% a year, charged monthly
• Switching costs: $3,000, paid upfront
• Rates never change

The same maths works in any currency.

Take the 25-year option first. The repayment drops by $108.17 a month. Divide the $3,000 cost by that monthly saving and it takes about 28 months to break even. After that, you’re money ahead.

Over the full term, total interest is $32,450.81 lower. Take off the $3,000 in costs and the net saving is $29,450.81.

But if you expect to sell or switch again before you hit break-even, the costs may eat the saving.

The term trap

Now look at the 30-year column.

Stretching the loan back out to 30 years cuts the repayment by $264.80 a month. Feels like a big win. It isn’t. You’ve just signed up for five more years of repayments, and total interest climbs to $405,431.84. That’s $46,466.52 more than staying put with the current loan, even at the lower rate.

A lower repayment and a lower total cost are not the same thing. Some people refinance to a lower rate and keep paying their old repayment amount anyway. The loan finishes sooner and the saving grows.

There are times when a smaller repayment really does matter more, like when cash is tight. That’s a genuine trade-off: breathing room now against more interest later. Only you can weigh it.

Adding other debts to a home loan

Some people refinance to roll a car loan or a credit card balance into their home loan at a lower rate. The rate drops. But that debt might now take decades to repay instead of a few years, so total interest can end up higher. And there’s a bigger issue. That debt is now secured against your home. If repayments can’t be kept up, secured debt puts the home at risk.

Questions to work through before you refinance

Grab a pen and answer these on paper:

• What will switching cost in total, including any break costs?
• How many months until the saving covers those costs?
• How long do I expect to keep this loan?
• What term will the new loan run for, and what’s the total interest?
• What features would I gain or lose?

Our guide to comparing the total cost of credit shows how to put different loans side by side.

If repayments are already hard to cover, refinancing may not be possible, or may not help. Free debt help is confidential and can talk through your options with you.

Common questions

How does refinancing a mortgage work?

A new loan pays off your existing mortgage in full. From then on, you make repayments on the new loan, which can have a different rate, term or features.

Is it worth refinancing for a lower rate?

It depends on the switching costs, how long you’ll keep the loan and the term you pick. Divide the costs by the monthly saving and you’ll see how long the switch takes to pay for itself.

Does refinancing restart the loan term?

It can. Many new loans run for a fresh full term, which lowers repayments but can push up total interest. Choosing a term that matches the time you have left avoids that.

Try it

The loan repayment calculator shows repayments and total interest for any balance, rate and term, so you can line options up side by side. You can also find your Freedom Date across all your debts.

General information only, not financial advice. Your situation is your own.