If you have a loan that is too costly or too risky to continue making payments, you may also refinance it for a better loan. Your financial circumstances may have changed since you first borrowed the capital, and more favorable terms may be available to you now.
In this article, we are going to discuss:
- What is loan refinancing?
- Is refinancing a loan a good idea?
- Why a ‘refinance loan’?
- What process you should follow for hitting a favorable refinancing option?
- What are the common loans which get refinanced?
- How does loan refinancing work?
- Is it better to refinance with the current lender?
- Is there a downside to refinancing?
- Why do banks refinance loans?
What is loan refinancing?
Loan refinancing relates to the process of revising and modifying current credit agreements — usually for loans or mortgages. If a company or person wants to refinance a loan agreement, it means they essentially seek to revise its interest rate, payment schedule, and/or other provisions set out in the contract. And if the same is approved, the borrower gets a brand-new contract that replaces the original agreement.
In simple words, loan refinancing is nothing but obtaining a loan that repays your existing loan. It can be materialized by applying for a new loan, either with the original lender or a different lender.
Is refinancing a loan a good idea?
Firstly, borrowers generally seek to refinance certain loan obligations to become entitled to more favorable borrowing covenants, for instance, to move from a variable-rate loan to a fixed-rate loan. Secondly, loan refinancing grabs their attention in the hope that the new loan may be a lower-cost loan.
To be precise, the goal is to attract better interest rates for the remaining principal amount of an existing loan. Now, there may be two scenarios where you can get a loan refinancing deal at lower interest rates:
Situation 1: Where market interest rates for business loans have dropped as per RBI policies
Situation 2: Where your financial situation/income has risen and your individual/company’s credit score has improved, since the time of taking the original loan (this way, banks may consider offering you a lower-cost loan).
Thus, refinancing a loan may reap some common benefits like it may lower your monthly payments (i.e., lower EMIs), change the duration of the loan, or reduce your interest rate as well. Essentially, most consumers choose to refinance their loans when interest rates drop, which may be due to national monetary policy, economic cycle, and market competition.
Why a ‘refinance loan’?
Loan refinancing can provide several benefits. Here is a checklist of some advantages that refinancing might render:
- Decrease/ Increase in the loan tenure, or
- Lower interest rates, or
- Lower monthly payments or EMIs, or
- Consolidation of multiple loans into a single one, or
- Change of loan type (fixed-rate or variable-rate), or
- Paying off a loan that’s due
What process you should follow for hitting a favorable refinancing option?
For heading towards a refinancing option, a borrower needs to gauge the relative cost of refinancing to find out whether it will be profitable or not. The following steps should be followed:
- Check whether your current lender allows refinancing. One ought to peruse loans from a variety of lenders before approaching a bank with his/her refinancing request.
- Take all the refinancing-related costs into proper consideration, including the processing fees of the new loan, origination fees, or any balance transfer charges.
- Make a comparison. Evaluate the existing loan, the outstanding amount and tenure left, and the interest to be paid. Compare such outlay with the principal amount of the new loan, the tenure and its interest payments, adding up prepayment penalties, and the new loan’s processing charges. Compare the aggregate cost of the two to check the viability of the refinancing option. If the total outlay of the new loan is lesser than the unmet cost of your current loan, you should go for it.
- Apply for a loan refinance and get approval.
- Carry out the settlement of your previous payoffs.
What are the common loans which get refinanced?
The most common loans that are typically considered for refinancing comprise mortgage loans, home loans, car loans, and student loans.
- Home loan refinancing
- Student loan refinancing
- Car loan refinancing
- Business loan refinancing
How does loan refinancing work? – Example
Let us comprehend the meaning of ‘refinance’ with the help of an example. A business loan of Rs. 20 lakhs at 21.25% rate of interest, which is outstanding for a term of 4 years, would give cost-savings if it is refinanced from a bank at 18% rate of interest for the same period of remaining 4 years.
*The calculation has been done using the PMT formula, which reads as:
E = P x r x (1 + r) ^ n / [(1 + r) ^ n – 1]
Is it better to refinance with the current lender?
You are likely to have a relationship with your lender, and they will know your payment track record. This can give you leverage to get discounts or special deals, particularly if you have an outstanding credit record of on-time payments. Some possible benefits of refinancing with your current lender may be – a quicker and easier loan process, possible break on closing costs, negotiation of better terms, a reward for being a loyal customer, etc.
Is there a downside to refinancing?
Loan refinancing may also pose some challenges and is not a smart choice in certain circumstances. Let have a look at those:
Cost of transaction: The additional costs linked to refinancing vary from lender to lender, but they may cost a borrower anywhere from 3% to 6% of the outstanding principal in terms of refinancing fees. Such refinancing fees include application, origination, appraisal, inspection fees, and closing costs.
Higher interest: When you stretch out loan payments over an extended period, you eventually end up paying more interest on your debt (even when the refinance loan comes at a lower interest rate). You might enjoy lower monthly payments (EMIs), but such gain may be offset by the higher lifetime cost of borrowing.
For example, a borrower refinances his original 20% loan of Rs. 1,00,000 that is outstanding for a term of 12 months. A fresh loan of Rs. 1,00,000 is taken at a lower interest rate of 18% p.a., payable over a term of 2 years. Now, originally, the loan’s EMI would have cost Rs. 9,263, with a total interest of Rs. 11,161 and the aggregate payment of Rs. 1,11,161 over the life of the loan. On the flip side, if the borrower goes with refinancing, the new loan’s EMI would cost Rs. 4,992, with a total interest of Rs. 19,819 and the aggregate payment of Rs. 1,19,819 over the life of the loan. Here, undoubtedly, the new loan shall prove to be more expensive to the borrower even though it offers a lower interest rate and lowers EMI. Therefore, sometimes refinancing may not be a viable option for you.
When should you not refinance?
It is not advisable to refinance your loan if costs don’t justify it and you are nearly through with your loan repayment. Nevertheless, barring certain cases, loan refinancing is proven to be favorable to borrowers, provided they are considerate of their net savings from such refinancing.
Why do banks refinance loans?
So far, we saw how a consumer or borrower can benefit from refinancing his/her loan. But, most of you must be intrigued to know the reason lying behind a bank’s choice to refinance loans.
Well, refinancing a loan will save you money by reducing the interest rate, but it also allows you to pay a fee. For example, you might have to pay an application fee that allows institutions to make more profit. If you refinance a mortgage, you will still have to repay the closing costs.
However, this does not mean that refinancing is not a good idea. It may potentially be a win-win experience, depending on your situation.
Another reason why lenders would allow you to refinance is to prevent you from searching elsewhere for a lower rate. By providing the best rates, banks can sustain the investment of their account holders and provide a positive experience to encourage future business.
When you are trying to determine whether to refinance, the easiest thing to do is run the math and find out how much you are going to save and whether it is worth the fees you are going to have to pay.
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