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)
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.
Risks
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.
Refinancing lenders often require a percentage of the total loan amount as an upfront payment. Typically, this amount is expressed in "points" (or "premiums"). 1 point = 1% of the total loan amount. More points (i.e. a larger upfront payment) will usually result in a lower interest rate. Some lenders will offer to finance parts of the loan themselves, thus generating so-called "negative points" (i.e. discounts).
Types (US loans only)
No Closing Cost
Borrowers with this type of refinancing typically pay few upfront fees to get the new mortgage loan.This type of refinance can be beneficial provided the prevailing market rate is lower than the borrower's existing rate by at least 1.5 percentage points.
However, what most lenders fail to disclose is that the money a borrower save upfront is being collected on the back end through what's called yield spread premium (YSP). Yield spread premiums are the cash that a mortgage company receives for steering a borrower into a home loan with a higher interest rate. The latter will even eventually lead to borrowers overpaying.
True No Closing Cost mortgages are usually not the best options. When the borrower pays out of pocket for their closing costs, they are better able to understand all the costs associated with the loan. In most cases, the borrower is also able to negotiate the fees for the appraisal and escrows down to a reasonable cost. Sometimes, when wrapping closing costs into a loan, borrowers forget about the fees because they are usually not coming into the loan with any money.
Cash-Out
This type of refinance may not help lower the monthly payment or shorten mortgage periods. It can be used for home improvement, credit cards, and other debt consolidation if the borrower qualifies with their current home equity; they can refinance with a loan amount larger than their current mortgage and keep the cash difference.
See also
(source:wikipedia)
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