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What is Refinancing?

Aparna Iyer Mar 17, 2019
Refinancing refers to replacing the current debt obligation with a new loan that has relatively favorable repayment terms.
Refinancing is the process of paying off an existing secured loan by obtaining a new loan, of the same size, that is again collateralized with the same property as the old loan. Obviously, refinancing does not eliminate one's debt obligations, since it only replaces an old loan with a new one.
People generally refinance in order to save money on interest payments. However, one must weigh the proposed savings against the cost of refinancing before embarking on the same.

Mortgage Refinancing

Mortgage refinancing refers to paying off an existing mortgage with a new one. Refinancing a mortgage results in using the same house as a collateral for obtaining a new mortgage to replace the existing loan.
Although, to the casual observer, refinancing doesn't seem to make sense, the logic behind it can range from trying to benefit from a fall in the interest rates to the desire to shorten the term of the existing mortgage. The following are the popular reasons for mortgage refinancing.

Change in the Interest Rate

This is one of the main reasons behind refinancing. It may help a homeowner who is paying a high rate of interest on the existing mortgage, obtain another mortgage that carries a lower rate of interest. Refinancing to a lower rate of interest is beneficial since the homeowner is now required to pay less in lieu of interest.
It is contingent on the ability of the borrower to procure financing at a favorable rate. This, in turn, is a function of his/her credit scores. Sometimes, a change in market conditions may result in the easy availability of low interest mortgage loans.
A fixed rate mortgage carries a fixed rate of interest, while an adjustable rate mortgage bears an interest rate that fluctuates with the prime rate. Hence, an adjustable rate mortgage has a cap and a floor to ensure that the interest rate does not increase or decrease indefinitely.
Changing from a fixed rate level payment mortgage to adjustable rate mortgage is desirable when rate of interest declines and the trend is expected to continue for a certain time. In this situation, the borrower, who is paying the mortgage loan at a fixed rate of interest, may choose to avail the facility of repaying the loan at a lower rate of interest.
Refinancing from adjustable rate mortgage to fixed rate mortgage is needed if  interest rates are rising and the trend seems to continue for a substantial time. One needs to bear in mind that refinancing to adjustable rate mortgage is risky compared to a fixed rate of interest as the former exposes  homeowner to payments based on fluctuating mortgage rates.

Changing the Term of the Mortgage

A homeowner may be interested in changing the term of the mortgage for various reasons. For instance, a homeowner who is interested in expediting mortgage payments may prefer decreasing the term of the mortgage. The cost would be larger monthly payments as a penalty for reducing the term of the mortgage.
However, one must remember that decreasing the term of the loan obligation is possible only if monthly payments are higher, since one is required to pay a larger portion of the principal on a monthly basis.
Increasing the term of the mortgage may be an option for people who are finding it difficult to keep up with the regular principal and interest payments. Such people may prefer refinancing to a mortgage with a greater repayment period.

Auto Refinancing

Mortgage refinancing seems to make a great deal of sense. But what is car refinancing? Is it sensible to refinance a car loan? Car refinancing makes sense when the amount of the car loan is more than the worth of the automobile. This may happen because a person obtained the first car loan from a dealership at an unfavorable rate of interest.
However, auto refinancing is not as popular as mortgage refinancing since cars have a depreciable life of 7 years and the chances of refinancing the loan at a favorable rate of interest is highly unlikely.
Refinancing deserves careful contemplation. Mortgage refinancing may not be for people, wanting to change their main residence. It may be foolhardy if existing mortgage has prepayment penalties or if loan is nearing maturity. Cash-out refinancing, referring to refinancing for more than current debt, may not be advised as repaying loan may be complex.