Refinancing

Refinancing refers to applying for a secured loan intended to replace an existing loan secured by the same assets. The most common consumer refinancing is for a home mortgage.

Uses and Advantages of Refinancing Debt

Refinancing may be undertaken to reduce interest costs (by refinancing at a lower rate), to pay off other debts, to reduce one's periodic payment obligations (sometimes by taking a longer-term loan), to reduce risk (such as by refinancing from a variable-rate to a fixed-rate loan), and/or to liquidate some or all of the equity that has accumulated in real property during the tenure of ownership.

In essence, refinancing a mortgage or other type of loan can lower the monthly payments owed on the loan either by changing the loan to a lower interest rate, or by extending the period of loan, so as to spread the re-payment out over a long period of time. The money saved can be used to pay down the principal of the loan, thus further reducing payments. Alternately, refinancing can be used to transform available equity in one's house into ready cash, available for other purposes or expenses.

Another use of refinancing is to reduce the risk associated with an existing loan. Interest rates on adjustable-rate loans and mortgages shift up and down based on the movements of the various prime rates used to calculate them. By refinancing an adjustable-rate mortgage or so-called "Balloon" mortgage into a fixed-rate one, the risk of interest rates increasing dramatically is removed, thus ensuring a steady interest rate over time.

Finally, refinancing a loan or a series of debts can assist in paying off high-interest debt such as credit card debt, with lower-interest debt such as that of a fixed-rate home mortgage. The net savings between the two interest rates can then be applied either towards further paying down the debt, or other purposes. In addition, non-tax deductable debt, such as credit card or car loan debt, can be transformed into tax-deductable debt such as home mortgage debt, potentially lowering one's taxes or shifting one into a more advantageous tax bracket.

Types of Refinance

Rate and Term Refinance

This type of refinance refers to a change in the rate and term of an existing loan. A refinance is considered rate and term if the borrower secures a lower interest rate, or changes the terms of a loan to ensure a longer fixed period or a lower payment plan, without paying off any additional debts or taking any cash in hand.

Cash-Out Refinance

A refinance is considered cash-out when a borrower pays off other debts or advances money on top of their existing loan amount, while also changing the rate and term of the existing loan. It differs from a rate and term loan because the new loan amount is larger than the existing loan amount due to the additional cash taken with the new loan. If a borrower pays off credit cards or unrelated loans, or opens an equity line behind an existing mortgage, the new loan will be considered cash-out.

Risks and Disadvantages Associated with Refinancing

Certain types of loans contain penalty clauses triggered by an early payment of the loan, either in its entirety or a specified portion. In addition, there are also closing and transaction fees typically associated with refinancing a loan or mortgage. In some cases, these fees may outweigh any savings generated through refinancing the loan itself. Typically, one should only consider refinancing if one stands to save a substantial amount of money from doing so, either in the short or long-term, or if there is a need to extend the loan in order to pay for unexpected costs such as medical expenses.

In addition some refinanced loans, while having lower initial payments, may result in larger total interest costs over the life of the loan, or expose the borrower to greater risks than the existing loan, depending on the type of loan used to refinance the existing debt. Calculating the up-front, ongoing, and potentially variable costs of refinancing is an important part of the decision on whether or not to refinance.

Points

Refinancing lenders often require an upfront payment of a certain percentage of the total loan amount as part of the process of refinancing debt. Typically, this amount is expressed in "points" (also sometimes called "premiums", with each "point" being equivelant to 1% of the total loan amount. Therefore, if the refinance option selected involves paying three points, then the borrower will need to pay 3% of the total loan amount upfront. Most refinancing lenders offer a variety of combinations points and interest rates. Paying more points typically allows one to get a lower interest rate than one would be capable of getting if one paid fewer or no points. Alternately, some lenders will offer to finance parts of the loan themselves, thus generating so-called "Negative points" (also called discounts).

The decision of whether or not to pay points, and how many points to pay, should be taken in consideration of the fact that with points, one tends to trade a higher upfront cost in exchange for a lower monthly premium later on. Points can be paid out of the cash saved by refinancing the loan in the first place.

External links

• U.S. Department of Housing and Urban Development - Streamlining your Mortgage
• U.S. Department of Veteran's Affairs - Mortgage Refinancing Information
• U.K. Refinancing Information