Refinance : Meaning, Work, Types, Examples, Advantages & Disadvantages

What is Refinance?

Refinance is a word that refers to the process of raising a loan to pay off another loan. Refinancing lets people take advantage of lower interest rates of loans. People often refinance their loans to reduce the monthly payments or improve the loan terms. The borrowers chose this method to secure a better deal and more flexibility with the money. In essence, refinancing is a financial strategy that people exercise to replace an existing debt obligation with a new one, typically with more favourable terms.

Geeky Takeaways:

• Refinancing means getting a new loan to replace an existing one.
• This method is exercised to take benefit of lower interest rates on loans.
• The process of refinancing allows borrowers to adjust the terms of their debt to better suit their financial needs.
• There are various types of refinancing like mortgage refinance, auto loan refinance, personal loan finance, etc.

How does Refinance Work?

Refinancing is a financial strategy that gives a way to a borrower to change the terms of the loan and take benefit of the change in the rate of interest of the loans. The process of refinancing can vary depending on the type of loan being refinanced. The process involves the following:

1. Determining the Current Situation: Before taking any decision regarding the refinancing of the loan, a borrower must assess the current situation of the loan and his financial goals. If the financial situation of the borrower does not meet his overall goal and the loan terms are one of the reasons then he may opt for refinancing.

2. Look for Opportunities: After determining the current financial situation, the borrower should look for options and offers that might benefit him. This involves comparing the interest rates, fees, and other terms of different banks or financial institutions to find the most favourable refinancing offers.

3. Raising New Loan: Borrower raises a new loan. This involves the paperwork and payment of the cost of raising the loan. The borrower will choose a new loan that will be more beneficial than the existing one in terms of interest rates and conditions of the loan.

4. Paying off the Debts: The funds raised through new loans are used to pay off the existing debts whether it be a principal amount or the interest on the loan or penalty. Sometimes, the additional funds are used by the borrowers to expand the business or to write off other expenses.

5. Payment of New Loan: The previous loan gets paid off with the funds of the new loan but the borrower needs to start the monthly payment of the new loan so raised according to the agreed terms.

Types of Refinancing

1. Mortgage Refinance: It is a refinancing where an owner of a house replaces the existing mortgage with a new mortgage. The foremost objective of doing mortgage refinancing is to take advantage of lower interest rates. Mortgage refinancing often involves making a check on the credit of the borrower. A higher credit score can help borrowers qualify for better interest rates and terms. The mortgage refinancing further has the following types of refinancing.

• Rate and Term Refinancing: This is one of the kinds of mortgage refinance that mainly focuses on getting a new loan with better interest rates and terms of the existing loan.
• Cash-In Refinancing: Cash-in refinance is used by the borrower to reduce the outstanding loan amount and decrease the loan-to-value ratio by making a cash payment at the time of refinancing.
• Cash-Out Refinancing: Cash-out refinance is a method where a person borrows a new loan more than the amount of an existing loan and the difference between the new and existing loan is received by the borrower in cash.

2. Auto-Loan Refinancing: The main idea of auto-loan refinancing is to replace an existing auto loan with a new one with better interest rates. This kind of refinancing is generally practised by owners of vehicles to change the debt obligations which is attached to their vehicles.

3. Business Loan Refinancing: Business loan refinancing is used to exchange the existing business loan with a new loan. By using this method companies get advantages like lower interest rates and improvement in the credit score. It also allows businesses to access additional capital by borrowing more than the existing loan balance. Companies may use this amount to expand, purchase inventory, pay off other debt, or other business needs.

4. Consolidation Refinance: Consolidation refinance is a financial strategy in which a borrower combines multiple loans into one single loan with the process of refinancing. It simplifies the monthly payment of instalments of loans and can result in overall interest savings.

5. Personal Refinance: Personal refinance involves removing the existing personal loan by raising a new one. Individuals with multiple personal loans or high-interest debts may choose to consolidate their debts by refinancing into a single personal loan. It is a strategy used by people to improve financial well-being.

Examples of Refinancing

1. Mortgage Refinance: Mr A has 20 years of fixed rate mortgage. The rate of interest on this loan is @9%. At present, due to some economic factors, the rate of interest has fallen to 6%. Now, Mr A can take advantage of the decreased rate of interest by refinancing their existing mortgage loan with the new one of @6%.

2. Consolidation: Sam who is a student of ABC College, has taken a few loans for his studies, which can be termed as education loans. He is facing issues with the monthly payment of several loans. It is becoming a cumbersome process to keep track of his payments of various loans. To overcome this situation, he plans to refinance his loans by raising a new single loan. This will benefit him to maintain track of his monthly payments and will make the process simple.

3. Business Loan: Zera Ltd. is a public company that has raised a few business loans. It is seen in the financial data of the company that the cost of the loans is getting high and monthly payment of loans is becoming a complicated task. Zera ltd. would want to reduce its cost as it will directly affect the profit of the business. Refinancing the loan would help the company to lower the cost and make the payment process easy and simple.

Advantages of Refinancing

1. Low-Interest Rates: The main objective of exercising the option of refinancing is that the borrower gets the benefit of lower interest rates when he exchanges an existing loan with a new loan. Lower interest rates help to reduce the monthly payments and overall cost.

2. Consolidation: Some kind of refinancing allows the borrower to consolidate their existing multiple loan into a single loan which helps them to simplify the payment of loans and streamline the financial management. Sometimes, the interest rate of various existing loans is higher, and refinancing the loans helps people to consolidate those loans into ones with a low interest rate.

3. Better Loan Terms: Refinancing allows borrowers to adjust the terms of their loan, such as extending or shortening the repayment period and allows them to align the terms with their financial goals. Improving the loan terms provides businesses with an improved cash flow statement.

4. Capital Access: Businesses get access to additional capital by borrowing more than the existing loan balance. Companies may use this amount to expand, purchase inventory, pay off other debts, or other business needs. In cash-out refinance also, a borrower can access the equity in their home for major expenses.

5. Credit Score Improvement: By taking a new loan, the borrowers pay off the existing loan which results in their improved credit score. Timely payments from refinancing can positively impact the credit score over time.

Disadvantages of Refinancing

1. Increased Monthly Payments: In refinance, borrowers tend to shorten their period for repayment of loans. Shortening the repayment period will have a direct impact on the monthly payment. The monthly payment of the person will likely increase due to this.

2. Minimal Savings: The process of refinancing includes various costs and a lengthy process. The benefit of saving from the refinancing can be minimal which might not be worth the efforts put into the process. Hence, it is not always necessary that a person will get an overall advantage of refinancing.

3. Penalties: Some existing loans may have prepayment penalties that can reduce the potential savings if not considered before refinancing. Prepayment penalties are imposed for paying off the loan early. These penalties should be considered in the cost-benefit analysis.

4. High Cost: It is one of the major drawbacks of the refinancing process. There are various costs involved in the process of refinancing such as the cost of closing the loan, loan origination fees, cost of other paperwork, etc. These costs must be considered before refinancing.

5. Impact on Credit Score: The process of refinancing may have a temporary negative impact on the credit score of the person. The impact must be considered by the person if he is planning to take other loans.

What is Corporate Refinancing?

Corporate refinancing is the method of restructuring the existing debts of a company to reorganize its financial responsibilities. It is done by the companies for various reasons such as increasing maturity period, improving the credit score or improving the cash flow of the company. Companies take advantage of economic changes such as a decrease in the rate of interest on loans due to various factors, changes in the terms of the loans, introduction of schemes, etc. A company with asset-based financing may refinance to access additional funds or secure more favourable terms based on the value of its assets. The companies can make use of the additional funds to expand the business or to maintain the inventory of the business. When a company requires financing for expansion or working capital it tends to refinance its existing credit facilities to accommodate the funding needs. The reason for corporate refinancing can be a reduction in the company’s revenue, a threat to solvency, consequences of litigation, insufficient investments, etc.

Refinance – FAQs

What is the impact of refinancing on credit score?

At the time of refinancing, the credit score may get a negative impact for a temporary period but after a period of time it will lead to overall growth in the credit score.

What types of loans can be refinanced?

There are various types of loans that can be refinanced such as mortgage loan, auto loans, student loans, personal loans, business loans, etc.

What is the use of refinancing?

People may consider refinancing to take advantage of lower interest rates, reduce monthly payments, consolidate debt, change loan terms, or access additional funds for specific purposes.

Is it possible to refinance the loans more than once?

Yes, it is possible to refinance the loan for multiple times. But it depends on the financial situation of the borrower and market condition.