What Is Refinancing?
Refinancing is the process of revising and replacing the terms of an existing credit agreement, commonly a loan or mortgage. When a business or an individual decides to refinance, they aim to make favorable changes to their interest rate, payment schedule, or other contractual terms. An approved refinancing results in a new contract that supersedes the original agreement.
Borrowers often pursue refinancing when the interest-rate environment changes significantly, creating opportunities for savings on debt payments.
Key Benefits
- Favorable Loan Terms: Refinancing usually results in improved loan terms like lower interest rates and adjusted payment schedules.
- Economic Response: Borrowers tend to refinance when interest rates decline to capitalize on the potential savings.
- Credit Re-evaluation: Refinancing involves re-assessing the borrower’s creditworthiness and financial situation.
- Popular Loans for Refinancing: These include mortgage loans, car loans, and student loans.
How Refinancing Works
Consumers typically pursue refinancing to secure more beneficial borrowing terms in response to changing economic conditions. The objectives may range from reducing interest rates, altering the loan duration, to switching mortgage types from a fixed rate to an adjustable rate or vice versa.
Borrowers may refinance for better terms due to an improved credit profile or changes in long-term financial goals. Debt consolidation into a single, lower-interest loan is another common reason for refinancing.
Because interest rates fluctuate with the economic cycle and market competition, many consumers refinance when rates drop.
Refinancing Steps
- Evaluate Refinancing Need: Determine if the interest climate or personal financial strategy warrants refinancing.
- Contact Lender: Approach your existing or a new lender and complete a refinancing application.
- Credit Re-assessment: The lender evaluates your creditworthiness and financial status.
Commonly refinanced loans include mortgages, car loans, and student loans. Businesses may also refinance commercial property mortgages to take advantage of lower rates or improved credit standing.
Types of Refinancing
Various refinancing options cater to different borrower needs:
Rate-and-Term Refinancing
This classic option involves replacing the original loan with a new one featuring lower interest rates and improved terms.
Cash-out Refinancing
Borrowing against increased asset value, this option allows you to access the equity of an appreciated asset in exchange for a higher loan amount.
Cash-in Refinancing
Borrowers can reduce their loan-to-value (LTV) ratio or lower their payments by paying down a portion of the loan during refinancing.
Consolidation Refinancing
Ideal for those with multiple debts, this option consolidates multiple loans into one with a lower interest rate, cutting overall debt costs.
Pros and Cons of Refinancing
Pros
- Lower Payments: Reduction in monthly mortgage and interest expenses.
- Interest Rate Conversion: Switching from adjustable to fixed rates can introduce predictability and savings.
- Immediate Cash: Access tangible cash for urgent financial needs.
- Shorter Loan Term: Potential savings on total interest paid.
Cons
- Extended Loan Terms: Resetting to a longer term could increase lifetime interest costs.
- Rate Benefits: Fixed-rate mortgages won’t automatically adjust with falling interest rates, requiring additional refinancing to benefit.
- Reduced Equity: Possible decrease in homeowner equity during refinancing.
- Higher Payments: Shortened loan term could lead to higher monthly payments and refinancing-associated closing costs.
Example of Refinancing
Consider Jane and John, who have a 30-year fixed-rate mortgage at 8% interest locked in 10 years ago. With a decline in rates, they approach their bank to refinance at 4% for the remaining 20 years, significantly reducing their regular monthly payment.
Corporate Refinancing
Corporate refinancing reorganizes a company’s financial obligations, possibly restructuring existing debts or issuing new bonds at lower rates for better financial stability.
Purpose of Refinancing
Refinancing replaces an old mortgage with a new one offering more favorable terms. The lender pays off the old mortgage, leaving the borrower with a single, typically lower-cost new mortgage.
Reasons to Refinance a Home
- Favorable Loan Terms: Lowering interest rates and resultant monthly payments.
- Loan Term Modification: Changing the mortgage term for better alignment with financial goals.
- Extracting Value: Accessing equity from the home for debt payoffs or home renovations.
Credit Impact of Refinancing
While refinancing may temporarily affect your credit score due to a credit check, it typically results in long-term improvements by reducing overall debt and lowering monthly payments.
Conclusion
Refinancing allows borrowers to modify their current credit agreements, replacing them with more favorable terms. Lower interest rates significantly benefit homeowners by reducing mortgage costs. Whenever rates decrease, evaluating refinancing options can be advantageous.
Related Terms: credit agreement, fixed-rate mortgage, adjustable-rate mortgage, debt consolidation, loan-to-value ratio.
References
- Federal Trade Commission. “Mortgage Discrimination”.
