Refinancing is the process of replacing an existing loan with a new loan. Businesses and individuals can qualify for refinancing loans. One may want to refinance a loan because:
- Their current loan has high-interest rates.
- The current loan’s term is short, and you may want to extend it to a new longer repayment term.
- Since the first loan was issued, financial circumstances have changed, and advantageous loan terms may now be available on the market.
- The current loan is risky, and you want to lower the risk, among other things.
The reasons for refinancing a loan may vary from person to person but it is something to consider every now and then. When one’s financial status changes and their credit record becomes more favorable, shopping for a refinance loan may not be such a bad idea.
What is Refinancing?
Refinancing is the process of revising and replacing the terms of an existing credit agreement. Credit agreements that can be revised under refinancing include revolving loans, personal loans, building loans, home loans, store credit, and other types of credit.
Refinancing of loans is for the purpose of receiving new favorable terms such as better interest rates, better payment terms, and better terms stipulated on the current contract. A new loan replaces the old loan, therefore, entering a new contract with new terms and conditions.
When refinancing an existing loan, a strategy should be in place. A closer look at the repo rate and the lending rate can yield favorable results on the new loan. Furthermore, credit score and credit history play a crucial role in obtaining better terms on a new loan, therefore, these have to be up to date or industry acceptable.
Characteristics of Refinancing
- Refinancing a loan mainly happens when the lending rate becomes very low.
- The loan is available only to existing loan holders.
- New terms, interest rate, repayment schedule, and installments are renegotiated on the refinanced loan.
- Refinancing loans mainly consider home loans and vehicle loans.
- Re-evaluation of personal credit information is done before new terms can be agreed on.
How Refinancing Works
Refinancing is acquiring a new loan that has contractual stipulations that are more favorable than the active loan product that one has. The new loan (refinanced) will require a credit check. Those with bad credit ratings are unlikely to get a refinancing loan. The credit check will impact your credit score when your credit information is updated by the credit bureaus but the impact will be very low.
Evaluation of current credit status and current income will take place before issuing the refinancing loan. The new loan will come with new repayment terms, a new interest rate that is applicable to your new loan, and an installment amount that must be paid on a monthly basis.
New Installments will be lower than that of the older loan since interest rates would have decreased. However, one pays more in installments if their loan term reduces with the refinanced loan. Small loans can also be refinanced through a consolidation loan that also has a low-interest rate and renegotiated repayment plan.
What motivates individuals to refinance existing loans?
Interest rates are the great motivator for individuals to seek refinance loans, however, change in credit status and income also plays a relatively crucial role. Changes in interest rates happen all the time but major changes can happen once in a few years.
Borrowers target these major drops in repo rate to get better financial terms on their loans. Major drops in the repo rate are rare and are mostly caused by major economic shocks such as the Covid-19. Only those that are fortunate enough to maintain their income during this period are able to enjoy lower rates on their borrowing.
Changes in the repo rate are also caused by the monetary policy, the economic policy, and the market economy. High-interest rates are imposed so that individuals can take less credit whereas low-interest rates are encouraged to increase the demand for loans in the financial market.
Types of Refinancing
Cash-in refinancing is a refinancing option whereby the borrower pays a portion of an existing loan when refinancing the loan. This type of refinancing allows the borrower to reduce the total amount owed, in the process easing the burden of paying higher installments for a longer period of time.
Cash-out refinancing is the type of refinancing whereby the loan required to finance an asset is higher than the sum owed for an existing loan. Lenders are careful when issuing out this loan since the assumption is that if an asset has increased value on paper that asset can gain access to a loan equal to the asset’s value. . The loan is secured by the retail value of the asset.
Rate and term refinancing
Rate and term refinancing is a refinancing option that seeks lower interest rates and better loan terms. The lender will replace an old loan by paying it off, and in exchange, the lender will receive interest on the new loan issued to the borrower.
This is a consolidation loan that absorbs numerous loans into a single loan that is paid with a single monthly installment for the duration of a loan. Consolidation loans are popular in South Africa and offer a bigger loan to buy off the small debt that a client owes. The new loan will have low-interest rates. This loan is also subject to credit check and income status.
Pros and cons of Refinancing
- Interest rates are renegotiated on the new loan to lower the total loan payments over time.
- There are options of refinancing to choose from depending on which lender you want to use.
- The repayment term of the loan can be extended and it is ideal for those that feel over-indebted.
- Borrowers have a chance of dodging balloon payments on loans and can take a refinance loan to cover up.
- Interest rate agreement from the previous loan agreement can be converted. For example, changing variable interest rates to fixed interest rates on the new loan.
- A shorter payment period can be opted for to save money by paying less interest rate.
- Opting to repay loans for a longer-term may cause your loan repayment to increase.
- Refinancing comes with costs such as Initiation fees and administration fees.
- Risk to assets refinanced can increase, for example, when you take the cash-out refinancing loan, you may have to put your asset as collateral.
Refinancing is a great way to take advantage of the financial market if you have a good credit rating, have a change in your income status, the repo rate is very low and you have a large loan to pay off. Your loan repayment will most likely be lower and you will gain financially immediately or in the long run.