What is Refinancing?
Refinancing is defined as taking new debt obligation in exchange for an ongoing debt obligation or in other words it is merely an act of replacing an ongoing debt obligation with a new debt obligation with respect to certain terms and conditions like interest rates, tenure etc that can be based on economic factors like projected risks, inherent risks, currency stability, the country’s political stability, banking regulations, the country’s credit rating, etc.
Types of Refinancing Loans
A borrower must evaluate his needs and then accordingly choose the type of refinancing loan. Following are the types of refinance loans:
#1 – Cash-Out Refinancing
- This type of refinancing is common when there is a rise in the value of an underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates. that has the tendency to collateralizationCollateralizationCollateralization is derived from the term "collateral," which refers to a security deposit made by a borrower against a loan as a guarantee to recover the loan amount if s/he fails to pay. the loan. This transaction includes withdrawing equities or values of an asset in the exchange of a bigger loan amount.
- This means when the value of an asset rises, one can have access to its value with the help of a loan instead of selling it. This option enhances the overall loan amount and allows the borrower to gain immediate access to cash while continuing with the ownership of an asset.
#2 – Rate and Term Refinancing
This type of refinancing is the most commonly used one and it occurs when the loan amount is fully paid before replacing the same with another loan that offers low-interest payment options.
#3 – Consolidation Refinancing
- This type of refinancing option is considered best for some cases and it can be taken into use when investors take-up a loan that is way lesser than their ongoing average rate of interest across all other credit goods and services.
- Consolidation refinancing requires the individuals or companies to take up a loan at a low rate and then get rid of the ongoing debt with the same. Doing so will help the borrower in getting rid of his or her total outstanding principal with a lower rate of interest payments.
#4 – Cash-in Refinancing
This type of refinancing option allows the borrowers to pay down-payment for lowering their debt obligations.
How does it work?
- Refinancing takes place when an individual or entity modifies the interest rate, payment schedule, terms of an ongoing agreement, etc. This is the re-evaluation of an individual or company’s (borrower’) creditworthiness. Car loans, student loans, mortgage loans, etc are types of customer loans that are mostly preferred for refinancing.
- Commercial properties might always be chosen for refinancing by commercial investors and most of them would prefer to evaluate their company’s balance sheets for borrowing loans that are issued by the creditors for the purpose of deriving benefits as a result of improved credit profile or lower market rates.
Risks Involved in Refinance
- There are various risks of refinancing. In the banking sector, this risk is associated with the probability that a borrower may not be able to refinance through borrowing with respect to the repayment of the ongoing debt obligations. It is always assumed that the borrower might opt for another loan for paying the current lenders.
- Liquidity is another risk involved in refinancing. A borrower who is unable to refinance his or her ongoing debt obligations and does not even have sufficient funds in hand to repay his or her existing lenders might have to deal with liquidity issues.
- The borrower might also be declared as technical insolvencyInsolvencyInsolvency is when the company fails to fulfill its financial obligations like debt repayment or inability to pay off the current liabilities. Such financial distress usually occurs when the entity runs into a loss or cannot generate sufficient cash flow.. Though the assets of the borrower are greater than his or her liabilities, still they will not be able to raise the funds and this type of insolvency might result in bankruptcy.
- Lower Rate of Monthly Payments – It is the most important reason as to why borrowers these days are opting for refinancing options. A lower rate of interest will allow the borrower to reduce his loan payments and as a result of which, he will have to pay less on his acquired assets. The opportunity to pay less with respect to mortgage every month will also free additional cash in the budget and will help the borrower to accomplish his goals with respect to short-term and long term savings
- Availing Fixed-Rate Loans – Having an adjustable-rate loan can help the borrower save money in the short term but can be potentially dangerous if the payment rises all of a sudden as a result of the rate change. It offers fixed-rate loans option that can help the borrower to get rid of adjustable-rate options and feel secure.
Refinancing costsRefinancing CostsThe various costs incurred in the process of replacing an existing debt obligation with another debt under a new set of terms are referred to as the cost of refinancing. This is done to lower EMIs, lower interest rates, and take cash out from the home to make large purchases. a lot of money, generally 2 to 6 % of the amount that is borrowed which could be quite expensive for a borrower. A no-cost refinancing option can also be misleading as there are no separate charges with respect to closing costs. A shorter-term of refinancing might also mean paying more as principal amount every month by month which can in return increase the payment burden.
- Refinancing occurs when a current loan undergoes modification with respect to the payment schedule, interest rate, etc. It can be regarded as debt restructuring, only if the replacement of debt takes place under financial distress.
- The act of refinancing is subjected to various terms and conditions like banking regulations, borrower’s creditworthiness, the country’s credit rating, currency stability, banking regulations, inherent risksInherent RisksInherent Risk is the probability of a defect in the financial statement due to error, omission or misstatement identified during a financial audit. Such a risk arises because of certain factors which are beyond the internal control of the organization., projected risks, etc. It also involves the re-evaluation of an individual’s or company’s credit terms and status.
This has been a guide to What is Refinancing & its Meaning. Here we discuss types of refinancing and how it works along with advantages and disadvantages. You can more learn about from the following articles –