Refinancing
Barron's Banking Dictionary:
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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.
Gale Encyclopedia of Small Business:
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Refinancing
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.
Barron's Law Dictionary:
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Refinancing
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.
Wikipedia on Answers.com:
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Refinancing
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This article has multiple issues. Please help improve it or discuss these issues on the talk page.
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Refinancing may refer to the replacement of an existing debt obligation with a debt obligation under different terms. The terms and conditions of refinancing may vary widely by country, province, or state, based on several economic factors such as, inherent risk, projected risk, political stability of a nation, currency stability, banking regulations, borrower's credit worthiness, and credit rating of a nation. In many industrialized nations, a common form of refinancing is for a place of primary residency mortgage.
If the replacement of debt occurs under financial distress, refinancing might be referred to as debt restructuring.
A loan (debt) might be refinanced for various reasons:
- To take advantage of a better interest rate (a reduced monthly payment or a reduced term)
- To consolidate other debt(s) into one loan (a potentially longer/shorter term contingent on interest rate differential and fees)
- To reduce the monthly repayment amount (often for a longer term, contingent on interest rate differential and fees)
- To reduce or alter risk (e.g. switching from a variable-rate to a fixed-rate loan)
- To free up cash (often for a longer term, contingent on interest rate differential and fees)
Refinancing for reasons 2, 3, and 5 are usually undertaken by borrowers who are in financial difficulty in order to reduce their monthly repayment obligations, with the penalty that they will take longer to pay off their debt.
In the context of personal (as opposed to corporate) finance, refinancing multiple debts makes management of the debt easier. If high-interest debt, such as credit card debt, is consolidated into the home mortgage, the borrower is able to pay off the remaining debt at mortgage rates over a longer period.
For home mortgages in the United States, there may be tax advantages available with refinancing, particularly if one does not pay Alternative Minimum Tax.
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Risks
Most fixed-term loans have penalty clauses ("call provisions") that are triggered by an early repayment of the loan, in part or in full, as well as "closing" fees. There will also be transaction fees on the refinancing. These fees must be calculated before embarking on a loan refinancing, as they can wipe out any savings generated through refinancing.
If the refinanced loan has lower monthly repayments or consolidates other debts for the same repayment, it will result in a larger total interest cost over the life of the loan, and will result in the borrower remaining in debt for many more years. Calculating the up-front, ongoing, and potentially variable costs of refinancing is an important part of the decision on whether or not to refinance.
In some jurisdictions, varying by American state, refinanced mortgage loans are considered recourse debt, meaning that the borrower is liable in case of default, while un-refinanced mortgages are non-recourse debt.
Points
Main article: Point (mortgage)
Refinancing lenders often require a percentage of the total loan amount as an upfront payment. Typically, this amount is expressed in "points" (or "premiums"). 1 point = 1% of the total loan amount. More points (i.e. a larger upfront payment) will usually result in a lower interest rate. Some lenders will offer to finance parts of the loan themselves, thus generating so-called "negative points" (i.e. discounts).
Types (US loans only)
No Closing Cost
Borrowers with this type of refinancing typically pay few if any upfront fees to get the new mortgage loan. This type of refinance can be beneficial provided the prevailing market rate is lower than the borrower's existing rate by a formula determined by the lender offering the loan. Before you read any further do not provide any lender with a credit card number until they have provided you with a Good Faith Estimate verifying it is truly a 0 cost loan. The appraisal fee cannot be paid for by the lender or broker so this will always show up in the total settlement charges at the bottom of your GFE.
This can be an excellent choice in a declining market or if you are not sure you will hold the loan long enough to recoup the closing cost before you refinance or pay it off. For example, you plan on selling your home in three years, but it will take five years to recoup the closing cost. This could prevent you from considering a refinance, however if you take the zero closing cost option, you can lower your interest rate without taking any risk of losing money.
In this case the broker receives a credit or what's called yield spread premium (YSP). Yield spread premiums are the cash that a mortgage company receives for originating your loan. The broker provides the client and the documentation needed to process the loan and the lender pays them for providing this service in lieu of paying one of their own loan officers. Since a brokerage can have more than one loan officer originating loans, they can sometimes receive additional YSP for bringing in a volume amount of loans. This is normally based on funding more than 1 million in total loans per month. This can greatly benefit the borrower, especially since April 1, 2011. New laws have been implemented by the federal government mandating that all brokers have set pricing with the lenders they do business with. Brokers can receive so much YSP that they can provide you with a lower rate than if you went directly to the lender and they can pay for all your closing cost as opposed to the lender who would make you pay for all the third party fees on your own. You end up with a lower rate and lower fees. Since the new RESPA law as of April came into effect in 2011, brokers can no longer decide how much they want to make off of the loan. Instead they sign a contract in April stating that they will keep only a certain percentage of the YSP and the rest will go toward the borrowers closing cost.
True No Closing Cost mortgages are usually not the best options for people who know that they will keep that loan for the entire length of the term or at least enough time to recoup the closing cost. When the borrower pays out of pocket for their closing costs, they are at a higher risk of losing the money they invested. In most cases, the borrower is not able to negotiate the fees for the appraisal or escrow. Sometimes, when wrapping closing costs into a loan you can easily determine whether it makes sense to go with the lower rate with closing cost or the slightly higher rate for free. Some cases your payment will be the same, in that case you would want to choose the higher rate with no fees. If the payment for 4.5% with $2,500 in settlement charges is the same for 4.625% for free then you will pay the same amount of money over the length of the loan, however if you choose the loan with closing cost and you refinance before the end of your term you wasted money on the closing cost. Your loan amount will be 2,500 less at 4.625% and your payment is the same.
Cash-Out
Main article: Cash out refinancing
This type of refinance may not help lower the monthly payment or shorten mortgage periods. It can be used for home improvement, credit cards, 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 out.
See also
References
External links
- U.S. Department of Housing and Urban Development - Streamlining your Mortgage
- U.S. Department of Veteran's Affairs - Mortgage Refinancing Information
- Good Neighbor Next Door - FHA Good Neighbor Next Door
- Indian Home Loan Guarantee Program - Indian Home Loan Guarantee Program
- HUD - Information about HUD
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Copyrights:
Barron's Banking Dictionary
Dictionary of Banking Terms. Copyright © 2006 by Barron's Educational Series, Inc. All rights reserved.
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Gale Encyclopedia of Small Business
Encyclopedia of Small Business. Copyright © 2002 by The Gale Group, Inc. All rights reserved.
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Barron's Law Dictionary
Law Dictionary. Copyright © 2003 by Barron's Educational Series, Inc. All rights reserved.
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