Definition of Refinancing
Refinancing may refer to the replacement of an existing debt obligation with a debt obligation under different terms. The terms and conditions of refinancing may vary widely by the type of debt involved and is based on several economic factors such as:
- the inherent and projected risk of the asset(s) backing the loan,
- the financial stability of the lender,
- credit availability,
- banking regulations,
- the borrower's credit worthiness, and
- the borrower's net worth.
If the replacement of debt occurs under financial distress, refinancing might be referred to as debt restructuring. The most common type of debt refinancing occurs in the home mortgage market.
Deciding to refinance debt can be a balancing act between the funds requested and the interest rate charged on the funds.
Refinanced debt must be finalized and the new loan terms approved before reporting it and replacing it for the old debt in the liability section.
Reasons to Refinance Debt
A loan or other type of debt can be refinanced for various reasons:
- To take advantage of a better interest rate or loan terms (a reduced monthly payment or a reduced term)
- To consolidate other debt(s) into one loan (a potentially longer/shorter term contingent on interest rate differential and fees)
- To reduce the monthly repayment amount (often for a longer term, contingent on interest rate differential and fees)
- To reduce or alter risk (e.g. switching from a variable-rate to a fixed-rate loan)
- To free up cash (often for a longer term, contingent on interest rate differential and fees)
Risks of Refinanced Debt
Calculating the up-front, ongoing, and potentially variable transaction costs of refinancing is an important part of the decision on whether or not to refinance. 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. Most fixed-term loans are subject to closing fees and points and have penalty clauses that are triggered by an early repayment of the loan, in part or in full.
Penalty clauses are only applicable to loans paid off prior to maturity and involve the payment of a penalty fee. The above-mentioned items are considered the transaction fees on the refinancing. These fees must be calculated before substituting an old loan for a new one, as they can wipe out any savings generated through refinancing.
In some jurisdictions, 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.