What Is Refinancing Risk?
Refinancing risk refers to the possibility that an individual or company would not be able to replace a debt obligation with new debt at a critical time for the borrower. Your level of refinancing risk is strongly tied to your credit rating. To avoid refinancing risk, lenders place great value on a borrower's history of paying down his or her debt reliably. However, external factors—such as interest rate movements and the overall condition of the credit market—often play an even larger role in a borrower's ability to refinance.
It is risky to assume that you will be able to pay down your existing debt with lower-interest debt because such a loan might not be available when you need it.
Understanding Refinancing Risk
Refinancing—replacing debt that is coming due with new debt—is common for both businesses and individuals. A major reason to refinance is to save money on interest costs. So typically, you need to refinance into a loan with an interest rate that is lower than your existing rate. The risk is that you might not be able to find such a loan when you need it.
Any company or individual can experience refinancing risk—either because their own credit quality has deteriorated, or as a result of external conditions. The Fed might have raised interest rates, for example, or credit markets might have tightened, and banks are not issuing new loans.
An inventory-based business can lose an entire year of operations if financing is unavailable at the terms that it needs to make a profit. Most businesses seek to limit their refinancing risk by working closely with lenders and investors to make sure that they understand the needs of the business.
Examining the "Risk" in Refinancing Risk
There are numerous ways in which a business or individual who has depended upon refinancing to cover their debt could end up losing money instead, as the following scenarios describe.
Refinancing Risk in Short-Term Debt
A homebuilding company takes on large amounts of short-term debt to fund its projects. The company's strategy was to regularly replace this debt with new debt. This worked well for a number of years until credit markets suddenly seized up because of a banking crisis and banks became unwilling to offer the company any new loans. As a result, the builder needed to sell some of its properties at a large discount in order to quickly raise money to cover its existing short-term debt obligations, which resulted in a sizable financial loss.
Refinancing Risk in Personal Mortgages
Borrowers often take on unforeseen risks when they assume that they will be able to refinance out of an existing adjustable-rate mortgage (ARM) at some future date—usually before an interest-rate reset date—to avoid an increase in their monthly payments. Interest rates might rise substantially before that date, or home price depreciation could lead to a loss of equity, which might make it hard to refinance as planned. This, of course, is essentially what happened in the subprime meltdown in 2007–08 when previously ignored refinancing risks came to fruition.
Refinancing Risk in Long-Term Debt
An electronics company makes a large offering of five-year bonds. The bonds are structured with small payments in the first four years followed by large balloon payments in the last year. The company assumes that it will be able to make these balloon payments with new bond issues. When the balloon payments come due, however, the company experienced a failed product launch that damages its profitability and financial condition. The company is unable to find financing to cover the balloon payments and must issue new equity at a discount to market prices. The company's stock price plunges dramatically as existing shareholders' holdings are diluted by the issuance of new shares.
- Refinancing risk refers to the possibility that a borrower will not be able to replace existing debt with new debt.
- Any company or individual can experience refinancing risk, either because their own credit quality has deteriorated, or as a result of market conditions.
- Because most investments involve a degree of risk, it is wise to avoid refinancing if it's unrealistic for you to assume the financial risk.
Refinancing a Mortgage For the Wrong Reasons
Refinancing a mortgage is not for everyone, even if mortgage rates are low. In general, refinancing makes sense if you want to lessen your monthly cash flow or pay off your home loan sooner. However, refinancing, itself can be costly and if you have not done your due diligence regarding the fees and closing costs of refinancing, you could get into even deeper debt.
Refinancing is just like applying for a mortgage all over again. It's a long tedious process—remember gathering all your pay stubs, bank statements, and so on—that some people would not be eager to repeat. Others may not want (or cannot) take the time out from work or raising a new family to undergo the process of refinancing. Moreover, depending on your personal situation, refinancing could even be an outright mistake.
Mitigating, or Avoiding, Refinancing Risk?
Most investments involve some level of risk. In general, it is impossible to make gains in business or life without taking risks. So, it's important to accept that taking on debt is risky. Typically—whether you're a professional investor, a consumer with credit card debt, or a homeowner trying to refinance—we incur a particular debt because its risk-reward profile is attractive and within our tolerance for risk.
The best way to take the risk out of refinancing is simply to avoid it. Don't refinance if it's unrealistic for you to assume the financial risk. Lenders, too, use the "tool" of avoidance by vetting you and your financial history thoroughly. They won't grant the loan if you seem to pose too much of a risk to them.
If, as in the examples above, however, you're already experiencing some negative results of refinancing risk, then the world of finance contains loads of information about how to mitigate it.