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Refinancing
refers to the replacement of an existing debt obligation with a debt
obligation under different terms. The most common consumer refinancing is
for a home mortgage.
If the replacement of debt
occurs under financial distress, it is also referred to as debt
restructuring.
A loan (debt) can be refinanced for various reasons:
1. To take advantage of a better interest rate (which will result in either
a reduced monthly payment or a reduced term)
2. To consolidate other debt(s) into one loan (this will result in a longer
term)
3. To reduce the monthly repayment amount (this will result in a longer
term)
4. To reduce or alter risk (e.g. switching from a variable-rate to a
fixed-rate loan)
5. To free up cash (this will result in a longer term) |
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Refinancing for reasons 2, 3, and 5 is usually undertaken by borrowers who
are in financial difficulty in order to reduce their monthly repayment
obligations, with the penalty that they will remain in debt for years
longer.
In the context of personal (as opposed to corporate) finance, refinancing
multiple debts makes management of the debt easier. If high-interest debt,
such as credit card debt, is consolidated into the home mortgage, the
borrower is able to pay off the remaining debt at mortgage rates over a
longer period.
For home mortgages in the United States, there may be tax advantages
available with refinancing, particularly if one does not pay Alternative
Minimum Tax.
Most fixed-term loans have
penalty clauses ('call provisions') that are triggered by an early repayment
of the loan, in part or in full, as well as 'closing' fees. There will also
be transaction fees on the refinancing. These fees must be calculated before
embarking on a loan refinancing, as they can wipe out any savings generated
through refinancing.
If the refinanced loan has lower monthly repayments or consolidates other
debts for the same repayment, it will result in a larger total interest cost
over the life of the loan, and will result in the borrower remaining in debt
for many more years. Calculating the up-front, ongoing, and potentially
variable costs of refinancing is an important part of the decision on
whether or not to refinance.
In some jurisdictions, varying by American state, refinanced mortgage loans
are considered recourse debt, meaning that the borrower is liable in case of
default, while un-refinanced mortgages are non-recourse debt.
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