What is refinance?
Refinance, also called refinancing or refi, is the process by which one loan is replaced by another loan, in most cases with more favorable terms. The new loan is used to pay off the original loan. Refinancing is done to take advantage of lower interest rates, to reduce monthly payments, to consolidate debt, or to free up cash.
In a refinance, an existing loan is paid off early with funds obtained from another loan. Refinancing only refers to loans paid off before their maturity date; if a loan is paid off at maturity, the second loan is simply new financing, not a refinancing. Both individual borrowers and businesses refinance loans, for a variety of reasons.
For homeowners, refinancing a mortgage is a very common strategy. Whenever interest rates fall below the rate at which a homeowner took out their original mortgage, it’s worth examining whether to refinance and save on interest charges. All loans have fees and closing costs, and some have pre-payment penalties, so a holder needs to decide whether a lower interest rate outweighs the various additional costs involved with refinancing.
The main types of mortgage refinance loan include:
- Rate and term refinance
- Cash-out and cash-in refinancing
- Home Affordable Refinance Program (HARP)
- FHA Streamline refinance
- Short refinance
A refinance can be done in order to lower monthly loan payments, typically by extending the term of the loan. If a debtor’s financial circumstances change — due to job loss or increased expenses — a lower monthly payment can receive financial pressures. However, this strategy usually leads to more costs over the life of the loan. Alternatively, a refi also can be used to shorten the term of a loan (and increase monthly payments).
Debt consolidation is another main reason to refinance. This approach is recommended when a person has multiple forms of credit that carry high interest rates, including high-interest credit card balances, or are having trouble managing multiple monthly payments. Banks, credit unions and debt consolidation companies offer special loans designed for debt consolidation. Often they are home equity line of credit (HELOC) using the borrower’s house as collateral.
Businesses refinance their loans frequently in order to manage their cash flow and help grow the business. SBA loans help small companies lower their payments to cope with changing trends. At larger companies, corporate refinancing involves the issuance of equity and corporate bonds in order manage interest payments.
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Perry bought a home with a 30-year, fixed-rate mortgage 15 years ago at an interest rate of 7 percent. He decides to refinance the loan because interest rates have plummeted since then. Perry gets a 15-year mortgage at 3.5 percent. This saves him a significant amount of money in interest. And because Perry had paid a big chunk of his principal with the old mortgage, his monthly payment with the new mortgage is lower.