Refinancing is a term used in banking and financial circles to describe the process of replacing an existing loan with a new one. The terms and conditions of the new loan are usually more favorable to the consumer than the existing one. Refinancing is most common in home mortgages and to a limited extent in auto loans.
Refinancing and Debt Restructuring
There is a fine line between refinancing and debt restructuring. When a new loan replaces an old loan due to financial problems like bankruptcy, it is called debt restructuring. In this process, the consumer negotiates with the creditor to reduce the amount of debt or make a change in the terms of payment. The idea is to help the consumer to pay off the loans without any defaults. Refinancing, on the other hand, is the replacement of an existing loan under normal circumstances. There are many reasons for refinancing a loan. The most popular reason is to get a lower rate of interest which can lead to lower monthly payments. Another popular reason is to reduce risk by moving from a variable-rate mortgage to a fixed-rate one. Some people also refinance to get some liquidity or to consolidate many loans into one. However, this can increase the duration of debt and so caution should be exercised.
Advantages and Disadvantages
There are advantages and disadvantages in refinancing. The main advantage is people get to be in a comfortable financial position with the new terms. The other advantage is the tax benefit that comes with refinancing. The major drawback is the penalty that comes with the early repayment of the old loan. This penalty should be calculated before getting into a new loan. Also, factors like up-front costs, processing costs and other variable costs should be taken into account. If numerous debts are consolidated into one, then the borrower is likely to be in debt for a longer period of time. This aspect should also be kept in mind while refinancing a loan.
Types of Refinancing
There are three kinds of refinancing options available to any borrower. The first is the fixed-rate mortgage. In this option, the borrower can lock in a fixed rate for the entire loan period. When an adjustable rate mortgage is converted to a fixed one with a lower interest rate, it results in sizable savings. Also, savings will accrue when an existing fixed rate mortgage is refinanced to a shorter term. This is because the borrower will pay lower interest and can gain more equity in a shorter span of time.
The second option is adjustable rate refinancing. This is a good option for home owners who are stuck with a high-interest fixed rate mortgage. It is also a good way to make use of the lower rates prevailing in the market. Cash out refinance is the third type. Under this method, a large amount of money is borrowed. The remaining balance in the old loan is paid off and the rest of the money is used to meet other expenses like college education.
In short, refinancing is a great way to reduce the monthly financial burden. However, one should be careful while deciding on the terms of the new loan.