Regardless of why you’re refinancing your loan, though, there’s a lot to consider to make sure it’s the right choice for you.
To help inform your choice, this article will review what loan refinancing is, why it’s typically done, and its pros and cons.
What is Loan Refinancing and Why Do It?
Business loan refinancing is the process of replacing one loan with a different one. Refinancing can also refer to replacing alternative types of financing such as an equipment loan
or merchant cash advance.
Those who have improved their financial situation may qualify for loans with better terms so they refinance to lower their total cost. Others refinance so they can take out a larger loan to avoid any gaps in financing. As mentioned earlier, you could also refinance to lower your monthly payments.
As you can see, small business loan refinancing can help you in a variety of ways, so it’s important to consider what refinancing can do for your business. To do that, examine the pros and cons of loan refinancing that we'll outline in this post.
The Pros of Loan Refinancing
1. Better loan terms for experienced entrepreneurs
If you took out a loan while your business was still maturing, you may be able to access better interest rates.
However, you’ll need to do the math to ensure that refinancing will save you money. Refinancing your loan means getting a new loan which comes with fees you wouldn’t have otherwise paid if you didn’t refinance. Still, for some entrepreneurs, the improved terms will be well worth refinancing.
2. Improved cash flow
Having free cash flow
gives you the flexibility to jump on opportunities when they come. Loan refinancing can unlock significant amounts of cash by lowering your monthly payment.
Even without improving your financial situation, you may find a loan with a longer term that enables you to make lower monthly payments. Just be sure that you’re aware of any additional expenses you may end up paying to access that lower monthly payment.
3. Lower borrowing costs
Though it depends on your specific situation, loan refinancing can significantly lower your borrowing costs. In the short and long term, by lowering your borrowing cost
you reduce the extent to which they erode your profits.
This can also improve your debt service ratio which makes it easier to qualify for additional financing if you need it. Plus, lower costs of capital make your business more attractive to investors or potential buyers.
The Cons of Loan Refinancing
1. It may not be worth the hassle
Figuring out whether loan refinancing is a good financial choice can be tricky because looks can be deceptive. While you might be able to get a lower interest rate, that’s not the only cost you need to consider. Fees for origination and appraisals
, among others, quickly eat into your potential savings.
In some cases, you could be subject to a prepayment penalty which will add to the expense of refinancing. When it’s all said and done, your savings can be minimal (or nonexistent). In those cases, refinancing is more hassle than it’s worth.
2. Potential for higher long-term costs
As we discussed earlier, a common reason for refinancing is to lower your monthly payment. One of the ways you can do this is by taking out a longer-term loan. Typically, the longer the term of your loan, the lower your monthly payment is, assuming all else is equal.
However, even though your payments might be lower, you can end up paying far more in interest over time. This is because, as your payback period extends, the proportion of each payment that goes to your loan principal is smaller
. The result is a larger total amount of interest expense over the life of the loan.
3. Negative impact on your credit score
When you refinance a loan, it’s essentially just like getting a new loan, which means that your new lender will request to review your credit report. This request will show up as a hard inquiry. Hard inquiries negatively impact your credit score for about one year.
Additionally, if you refinance an existing loan, you’ll reduce the age of your credit history. Since the age of your credit history makes up 15 percent of your personal credit score
, reducing it will negatively impact your score.
Conclusion: Know Your Goals and Do the Math
Refinancing decisions are not one-size-fits-all. However, once you establish clear goals for your refinancing strategy, it’s just a matter of doing the math.
For example, let’s assume you want to reduce your monthly payment.
To determine if refinancing is a good idea, start by finding out what your monthly payment would be on your refinanced loan. Then, add up the total cost of your new loan
and subtract it from your old loan. Finally, calculate the difference between your current and potential monthly payments.
With those numbers, you can decide if the additional cost of your new loan is worth the reduction in your monthly payments. If the reduction is significant, it might be worth it to pay a little more over the life of the loan. If your new business loan is less expensive, then it will be a win-win for your business.
Just remember not to chase inconsequential savings. Loan refinancing is a time-consuming process. So, a little savings over many years or slightly reduced payments may not be worth the hassle.
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