Refinance: definition and examples

Are you finding it difficult to make payments on an existing business loan or mortgage? Refinancing might help. A refinance loan often involves more advantageous terms than the original – but it doesn’t always pay off in the long run. Here’s what you need to know before you refinance.

What does refinance mean?

The refinancing process takes an existing credit agreement and revises its terms. One of the most common applications of this concept is with a refinance mortgage, which repackages a mortgage agreement to extend its payment schedule or decrease interest rates.

You can refinance nearly any type of debt. Whether a business or individual is refinancing their credit agreement, the goal is to end up with more favourable conditions. If the refinance loan is approved, the borrower signs a new contract that replaces the original.

There are two factors that will remain consistent between the original credit agreement and the refinanced loan.

• The original loan balances

• The original collateral

Although your loan agreement terms might be more favourable after refinancing, you can’t eliminate the original balance. In fact, many individuals take on more debt overall in exchange for reduced monthly payments. The same collateral is also required, whether it’s your home, car, or other assets.

Types of refinancing

There are several options when it comes to refinancing, including a variety of loan types and packages. Here are a few of the most common.

1. Cash-out refinance: Although you can’t get rid of the original collateral when you refinance, what happens if it has increased significantly in value? A cash-out refinance allows you to gain access to that increased asset value. While your total loan amount increases, you can walk away with a new agreement and cash in hand.

2. Cash-in refinance: The flip side of this is to use the increased asset value to pay down more of the loan, negotiating lower monthly loan payments.

3. Rate-and-term refinance: This is perhaps the most common scenario when refinance rates are reduced as part of the new loan agreement. The original loan is paid off, replaced with a new agreement involving lower interest payments.

4. Consolidation refinance: Are you repaying multiple loans at once? It may be more advantageous to consolidate your loans into a single loan with a more favourable interest rate. You then only need worry about repaying the single consolidation loan.

5. Corporate refinance: In the corporate world, a company might reorganise its financial obligations and debts. For example, a refinance in this context might involve issuing new corporate bonds with lower interest rates.

Loan refinancing example

We’ll use a mortgage agreement as a loan refinancing example. Imagine that Bill and Judy currently are paying off a fixed-rate mortgage with a 30-year loan term and 6% interest rate. However, since they began paying their mortgage off five years ago, interest rates have dropped due to changes in the economy.

Bill and Judy visit their bank to ask whether they can refinance mortgage rates. They are approved, refinancing the existing mortgage with a new interest rate of only 4%. This locks in the new refinance rates for the remaining 25 years of their loan agreement, saving a large chunk of money over time that would have been spent on interest.

Pros and cons of refinancing

As with any credit agreement, there are advantages and disadvantages to refinancing.

The benefits include:

• Lower monthly loan payments

• Lower interest rates

• Greater flexibility with interest rates

• Access to cash that has been tied up in collateral

• Shorter loan terms to pay off your debts faster

However, this option isn’t always the best financial decision. Here are a few potential setbacks:

• Reduction in home equity if you withdraw cash

• Monthly payments might increase with shorter loan terms

• Interest payments might cost more over time

It’s best to compare the terms and conditions carefully before agreeing to any new refinance agreement, so that you’re sure you’re coming out ahead. A break-even analysis can help you determine how long it takes for savings to surpass upfront costs.

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