Refinancing

The word refinancing refers to converting the existing debt obligation with a new debt obligation under new terms. These terms and conditions, however, differ widely by country, province/state.

This is because; the inherent risk emanating from political scenario, (volatile political environment creates uncertainties as opposed to stable political environment) and economical setting  (banking regulations, currency stability, level of inflation,  borrowers’ credit worthiness and credit rating etc), varies from one place to another.

In the developed world, the word “refinancing” is commonly used in mortgage backed housing loans.

In the case of financial distress, replacing of current debt obligation with new terms is called as debt restructuring.

A debt can be refinanced for various reasons:

• To take advantage of a lower interest rate (a reduced monthly payment or a reduced term)
• To combine other debt(s) into one loan (a potentially longer/shorter term contingent on interest rate differential and fees)
• To lower the monthly repayment amount (usually for a longer term, contingent on interest rate differential and fees)
• To lower or modify risk (e.g. A switch from paying interest under variable-rate method  to a fixed-rate loan)
• To free up cash (In general, this is done for a longer term, contingent on interest rate differential and fees)

For the last three reasons, normally, refinancing is agreed upon by those borrowers who are in financial distress. The new terms lowers monthly payment obligation along with the penalty that they will take longer to pay off their debt.

In the case of personal finance (as opposed to corporate finance), refinancing several debts makes management of the debt easier to some extent. For instance, high-interest debt, such as credit card debt, when consolidated into the home mortgage, the borrower is able to pay off the outstanding debt at mortgage rates over a longer period.

In the U.S., there are tax advantages available with refinancing should the home mortgage holder does not pay the Alternative Minimum Tax.

Risks:

A debt holder before embarking on refinancing scheme should consider some risks. Most fixed-term loans carry penalty clauses also known as “call provisions.  These are levied in case of an earl y repayment of the loan, in part or in full in addition to “closing” fees. Also, there are transaction fees on the refinancing scheme. These additional expenses should be borne in mind as they can wipe out any savings generated through refinancing.

Should the refinanced loan carries lower monthly repayments or consolidates other debts for the same repayment, the end result will be higher interest cost over the life of the loan, and will also keep the borrower under debts for a longer period of time. Accordingly, calculating the up-front, current, and potentially variable costs of refinancing is a significant part of the decision on whether or not to refinance.

In some jurisdictions, which vary among American state, refinanced mortgage loans are considered as recourse debt, signifying that the borrower is accountable in case of default, while un-refinanced mortgages are non-recourse debt.

Points

Refinancing lenders usually ask for a percentage of the entire loan amount as an upfront payment. In general, this amount is stated in “points” (or “premiums”); for instance,  1 point means 1% of the total loan amount. Thus, more points (i.e. a bigger upfront payment) will 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).

No Closing Cost (Available only in the U.S.): Borrowers under this form of refinancing usually pay few if there are any upfront fees, in order to obtain the new mortgage loan. This type of refinance can be advantageous only if the prevailing market rate is lower than the borrower’s existing rate by a formula determined by the lender offering the loan. Before the loan seeker reads any more, he/she should not provide any lender with a credit card number until they have provided with a “Good Faith Estimate” making sure it is truly a 0 cost loan. Since the appraisal fee is not payable by the lender or broker, it will always show up in the total settlement charges at the bottom of loan seeker’s “GFE.”

This can be an extremely beneficial preference in a declining market or if the debt holder is not sure whether he/she will hold the loan long enough to get back the closing cost before he/she refinance or pay it off. For example, if someone plans on selling his/her home in three years, but it can take five years to recoup the closing cost. This could stop anyone from considering a refinance; nevertheless if one adopts the zero closing cost option, then he/she can lower the interest rate without taking any risk of losing money.

In this case the broker gets a credit which is also called as yield spread premium (YSP). Yield spread premiums are the cash that mortgage companies obtains for originate the loan. The broker gives the client and the documentation required to carry one the process of the loan and the lender pays them for offering this service in return of paying one of their own loan officers. As the brokerage can have more than one loan officer originating loans, they can every so often receive bonus YSP for bringing in a volume amount of loans. This is usually based on funding more than 1 million in total loans per month.

This can immensely benefit the borrower, more particularly after April 1, 2011. New laws have been legislated by the federal government making it obligatory that all brokers set pricing with the lenders they do business with.

Brokers can get so much YSP that they can offer sometimes a lower rate than if you went directly to the lender and they can pay for all your closing cost; on the other hand a lender would make pay for all the third party fees on your own. As a result, the borrower ends up with a lower rate and lower fees. Following the new RESPA law as of April came into effect in 2011, brokers can no more fix on how much they want to make off of the loan. As an alternative they sign a contract in April stating that they will maintain only a definite percentage of the YSP and the remaining will go toward the borrowers closing cost.