Refinancing is a process whereby an existing debt is replaced with another financial obligation and different terms apply. The most common form is related to home mortgages. When pressing circumstances require the debt replacement, it is called debt restructuring.
With this instrument, the borrower enjoys lower monthly payments, lower interest rate, more flexible options, or no fees. The second loan is obtained to pay off a higher rate one. When high-interest debt, like credit card debt, is consolidated into the mortgage, borrowers can repay the outstanding balance at mortgage rates. A common reason to resort to refinancing is to borrow more funds against the market value of a property. However, a debt is refinanced for a variety of reasons. A borrower might want to consolidate his/ her existing obligations into one debt with a resulting longer term of repayment. They might seek to reduce the monthly payment amounts, again resulting into a longer term. Another reason to refinance is to alter or reduce the risk by substituting a variable-rate loan with a fixed-rate one. Finally, refinancing is done to free up some cash, with the loan term being extended.
Two types of refinancing are possible in the US. With cash-out, the minimum monthly payment may not be lowered or the mortgage period shortened. This type of instrument is used for credit cards, home improvement, and other types of debt consolidation in case the home equity of the borrower makes him a likely applicant. The loan amount will be larger than the mortgage, and the borrower can keep the cash difference.
No closing cost refers to a type of refinancing whereby the borrower pays some fees upfront as to obtain a new mortgage loan. This instrument can be of benefit on condition that the borrower’s existing rate is higher than the prevailing market rate with 1.5 or more percentage points. It should be kept in mind that what borrowers save upfront is later collected through yield spread premium or the money that the mortgage issuer gets for making borrowers go for a home loan payable at a higher interest rate. Eventually, borrowers end up overpaying.
No closing cost mortgages are typically not the best option. However, in many cases, the borrower will be able to negotiate the applicable fees, resulting in a reasonable cost.
There are ways to find out if refinancing is a good alternative to one’s existing debt. One is to follow the 2 percent rule whereby the interest rate is 2 percent lower than the interest rate on one’s current loan. This interest rate helps the borrower recoup the cost of the new loan on condition that he/ she does not plan to move soon. With low-cost and no-cost refinance loans, the costs of obtaining the new loan are included. However, these loans come with a higher interest rate compared to loans which don’t have the refinance costs included. Another disadvantage is that the borrower’s options are more limited if the credit market experiences a slump.