Refinancing

1. Banking. A loan that adds to the principal balance owed, usually for property or home improvements, and alters the payment amount and terms.

2. Finance. Issuing new securities at a lower interest rate, or extended maturity. Also called Refunding.

3. Real estate. To extend existing financing to new properties.

4. Mortgages. Revising a mortgage loan and modifying scheduled debt payments, often to reduce finance charges or to modify the loan payments.

Refinancing is the refunding or restructuring of debt with new debt, equity, or a combination of both. The refinancing of debt is most often undertaken during a period of declining interest rates in order to lower the average cost of a firm's debt. Sometimes refinancing involves the issuance of equity in order to decrease the proportion of debt in the borrower's capital structure. As a result of refinancing, the maturity of the debt may be extended or reduced, or the new debt may carry a lower interest rate, or some combination of these options.

Refinancing may be done by any issuer of debt, such as corporations and governmental bodies, as well as holders of real estate, including home owners. When a borrower retires a debt issue, the payment is made in cash and no new security takes the place of the one being paid off. The term "refunding" is used when a borrower issues new debt to refinance an existing one.

Corporate or Government Debt Refinancing

The most common incentive for corporations or governmental bodies to refinance their outstanding debt is to take advantage of a decline in interest rates from the time the original debt was issued. Another trigger for corporate debt refinancing is when the price of their common stock reaches a level which makes it attractive for a firm to replace its outstanding debt with equity. Aside from reducing interest costs, this latter move gives a firm additional flexibility for future financing; by retiring debt, the firm will have some unused debt capacity. Regardless of the reason for the refinancing, the issuer has to deal with two decisions: 1) Is the time right to refinance, and 2) What type of security should be issued to replace the one being refinanced?

If a corporation or governmental body wishes to refinance before the maturity date of the outstanding issue, they will need to exercise the call provision of the debt. The call provision gives the borrower the right to retire outstanding bonds at a stipulated price, usually at a premium over face amount, but never less than face value. The specific price which an issuer will need to pay for a call appears in the bond's indenture. The existence of a call premium is designed to compensate the bond holder for the firm's right to pay off the debt earlier than the holder expected. Many bond issues have a deferred call, which means the firm cannot call in the bond until the expiration of the deferment period, usually between five and ten years.

The cash outlay required by exercising the call provision includes payment to the holder of the bond for any interest which has accrued to the date of the call, and the call price, including premium (if any). In addition, the firm will need to pay a variety of administrative costs, including a fee to the bond's trustee. Of course, there will also be flotation costs for any new debt or equity that is issued as part of the refinancing.

Sometimes an issuer may be prohibited from calling in the bonds (e.g., during the deferred call period). In these instances, the issuer always has the opportunity to purchase its bonds on the open market. This strategy may also be advantageous if the outstanding bond is selling in the market at a price lower than the call price. Open market purchases involve few administrative costs. The corporation will recognize a gain on the repurchase if the market value is below the amount at which the corporation is carrying the bonds on its books (face value plus or minus unamortized premium or discount), or a loss on the repurchase if the market value is above the book value.

The major difficulty with open market purchases to effect a refinancing is that typically the market for bonds is "thin." This means that a relatively small percentage of an entire issue may be available on the market over any period of time. As a result, if a firm is intent on refinancing a bond issue, it almost always needs to resort to a call. This is why virtually every new bond that is issued contains a call provision. If an outstanding issue does not permit a call, another option available to the issuer is to seek tenders (offers to sell at a predetermined price) from current bond holders.

The new debt instrument issued in refinancing can be simple or complex. A corporation could replace an existing bond with traditional bonds, serial bonds (which have various maturity dates), zero-coupon bonds (which have no periodic interest payments), or corporate shares (which have no maturity date, but which may have associated dividend payments). One factor that a firm needs to consider is that the administrative and flotation costs of issuing either common or preferred shares are higher than for new debt. Furthermore, dividend payments, if any, are not tax deductible.

The decision to refinance is a very practical matter involving time and money. Over time the opportunity to refinance varies with changing interest rates and economic conditions. When a corporation anticipates an advantageous interest rate climate, it then analyzes the cash flows associated with the refinancing. Calculating the present value of all the cash outflows and the interest savings assists in comparing refinancing alternatives that have different maturity dates and capitalization schemes.

Mortgage Refinancing

Owners of residential or commercial real estate use a similar method to analyze their refinancing decisions. In residential real estate the conventional wisdom applies the "2-2-2 rule": if interest rates have fallen two points below the existing mortgage, if the owner has already paid two years of the mortgage, and if the owner plans to live in the house another two years, then refinancing is feasible. However, this approach ignores the present value of the related cash flows and the effects of the tax deductibility of interest expense and any related points.

Therefore, a better analysis of a mortgage refinancing decision should be conducted as follows: 1) Calculate the present value of the after-tax cash flows of the existing mortgage; 2) Calculate the present value of the after-tax cash flows of the proposed mortgage; 3) Compare the outcomes and select the alternative with the lower present value. The interest rate to be used in steps one and two is the after-tax interest cost of the proposed mortgage.

Further Reading:

Arsan, Noyan, and Eugene Poindexter. "Revisiting the Economics of Mortgage Refinance." Journal of Retail Banking. Winter 1993-1994.

Bierman, Harold, Jr., and Seymour Smidt. Financial Management for Decision Making. New York: Macmillan, 1986.

Freedman, Michael. "The Right Way to Borrow." Forbes. December 11, 2000.

Hoeschen, Brad. "Surge in New Home Mortgages Eases Loss of 'Refi' Business." Business Journal—Milwaukee. October 8,1999.

Sharpe, William, F., and Gordon J. Alexander. Investments. 4th ed. New York: Prentice-Hall, 1990.

Tower, Jonathan. "Rate Plunge Ignites a Boom in Refinancing Market." American Banker. August 8, 1997.

To repay existing debt with funds raised by creating new debt; usually implies selling a new bond issue to provide funds for redemption of a maturing issue. See recapitalization.

This article is missing citations or needs footnotes. Please help add inline citations to guard against copyright violations and factual inaccuracies. (February 2009)

Refinancing refers to the replacement of an existing debt obligation with a debt obligation bearing different terms. The most common consumer refinancing is for a home mortgage.

Contents 1 Advantages 2 Risks 3 Points 4 Types 4.1 No-Closing Cost 4.2 Cash-Out 5 See also 6 References 7 External links

Advantages

Refinancing may be undertaken to reduce interest rate/interest costs (by refinancing at a lower rate), to extend the repayment time, to pay off other debt(s), to reduce one's periodic payment obligations (sometimes by taking a longer-term loan), to reduce or alter risk (such as by refinancing from a variable-rate to a fixed-rate loan), and/or to raise cash for investment, consumption, or the payment of a dividend.

In essence, refinancing can alter the monthly payments owed on the loan either by changing the loan's interest rate, or by altering the term to maturity of the loan. More favourable lending conditions may reduce overall borrowing costs. Refinancing is used in most cases to improve overall cash flow.

Another use of refinancing is to reduce the risk associated with an existing loan. Interest rates on adjustable-rate loans and mortgages shift up and down based on the movements of the various indices used to calculate them. By refinancing an adjustable-rate mortgage into a fixed-rate one, the risk of interest rates increasing dramatically is removed, thus ensuring a steady interest rate over time. This flexibility comes at a price as lenders typically charge a risk premium for fixed rate loans.

In the context of personal (as opposed to corporate) finance, refinancing a loan or a series of debts can assist in paying off high-interest debt such as credit card debt, with lower-interest debt such as that of a fixed-rate home mortgage. This can allow a lender to reduce borrowing costs by more closely aligning the cost of borrowing with the general creditworthiness and collateral security available from the borrower. For home mortgages, in the United States, there may be certain tax advantages available with refinancing, particularly if one does not pay Alternative Minimum Tax.

Risks

Most fixed-term debt contains penalty clauses (known as "call provisions") that are triggered by an early payment of the loan, either in its entirety or a specified portion. In addition, there are also closing and transaction fees typically associated with refinancing debt. In some cases, these fees may outweigh any savings generated through refinancing the loan itself. Typically, one only rationally considers refinancing if the potential for a substantial cost savings exists, or if there is a need to extend the loan due to weak cash flow or other non-recurring commitments.

In addition, some refinanced loans, while having lower initial payments, may result in larger total interest costs over the life of the loan, or expose the borrower to greater risks than the existing loan, depending on the type of loan used to refinance the existing debt. Calculating the up-front, ongoing, and potentially variable costs of refinancing is an important part of the decision on whether or not to refinance.

Points

Main article: Point (mortgage)

Refinancing lenders often require an upfront payment of a certain percentage of the total loan amount as part of the process of refinancing debt. Typically, this amount is expressed in "points" (also sometimes called "premiums"), with each "point" being equivalent to 1% of the total loan amount. Therefore, if the refinance option selected involves paying three points, then the borrower will need to pay 3% of the total loan amount upfront. Most refinancing lenders offer a variety of combinations of points and interest rates. Paying more points typically allows one to get a lower interest rate than one would be capable of getting if one paid fewer or no points. Alternately, some lenders will offer to finance parts of the loan themselves, thus generating so-called "negative points" (also called discounts).

The decision of whether or not to pay points, and how many points to pay, should be taken in consideration of the fact that with points, one tends to trade a higher upfront cost in exchange for a lower monthly premium later on. Points can be paid out of the cash saved by refinancing the loan in the first place.

Types

No-Closing Cost

Borrowers with this type of refinancing typically pay few upfront fees to get the new mortgage loan.^{[citation needed]} In fact, as long as the prevailing market rate is lower than your existing rate by 1.5 percentage point or more, it is financially beneficial to refinance because there is little or no cost in doing so.^{[citation needed]}

However, what most lenders fail to disclose is that the money you save upfront is being collected on the back through what's called yield spread premium (YSP). Yield spread premiums are the cash that a mortgage company receives for steering a borrower into a home loan with a higher interest rate. The latter will even eventually lead to borrower's overpaying.

Cash-Out

This type of refinance may not help lower the monthly payment or shorten mortgage periods. It can be used for home improvement, credit card and other debt consolidation if the borrower qualifies with their current home equity; they can refinance with a loan amount larger than their current mortgage and keep the cash difference.

See also

• Refinancing risk
• Refunding

References

External links

• U.S. Department of Housing and Urban Development - Streamlining your Mortgage
• U.S. Department of Veteran's Affairs - Mortgage Refinancing Information

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