What is 'Refinance'
A refinance occurs when a business or person revises the interest rate, payment schedule and terms of a previous credit agreement. Debtors will often choose to refinance a loan agreement when the rate environment has substantially changed causing potential savings on debt payments from a new agreement.
BREAKING DOWN 'Refinance'
A refinance involves the reevaluation of an entities credit terms and credit status. Consumer loans typically considered for refinancing include mortgage loans, car loans and student loans. Business investors may also seek to refinance mortgage loans on commercial properties. Many business investors will also evaluate their corporate balance sheets for business loans issued by creditors that could benefit from lower market rates or an improved credit profile.
The current rate environment is typically a key catalyst for loan refinancings however an improved credit profile or a change in long-term financial plans can also lead borrowers to seek new credit terms. A common goal is to pay less interest over the life of the loan. Borrowers may also want to change the duration of the loan or switch from a fixed-rate to an adjustable-rate mortgage, or vice versa.
Interest rate environments are cyclical and as such are followed closely by consumers and businesses for new credit as well as credit refinancings. National monetary policy, economic cycles and market competition can be key factors causing interest rates to increase or decrease for consumers and businesses. In times of economic valleys interest rates may be lowered to help stimulate consumer spending and business investment. Economies in an expansion will typically see interest rates expanding as the economy improves. These factors can influence interest rates across all types of credit products including both non-revolving loans and revolving credit cards. In a rising rate environment debtors with floating rate interest products can expect to see their interest rates automatically increased and vice versa with a decreasing rate environment.
Refinance Loan Types
There are several different types of refinancing options. The type of loan a borrower decides on is dependent on the needs of the borrower. The most common type of refinancing is called the rate-and-term. This occurs when the original loan is paid and replaced with a new loan requiring lower interest payments. Another type of refinancing is the cash-out. Cash-outs are common when the underlying asset collateralizing the loan increases in value. The transaction involves withdrawing the value or equity in the asset in exchange for a higher amount. In other words, when an asset increases in value on paper, you can gain access to that value with a loan rather than selling it. This option increases the total loan amount but gives the borrower access to cash immediately while still maintaining ownership of the asset. Another refinancing option is referred to as the cash-in. The cash-in refinance allows the borrower to pay down the loan for a lower loan-to-value ratio or smaller loan payments.
In some cases a consolidation loan may also be an effective way to refinance. A consolidation refinancing can be used when an investor obtains a single loan at a rate that is lower than their current average interest rate across several credit products. This type of refinancing requires the consumer or business to apply for a new loan at a lower rate and then pay off existing debt with the new loan leaving their total outstanding principal with substantially lower interest rate payments.