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.
Refinancing may be undertaken to reduce
interest costs (by refinancing at a lower rate), to extend the repayment time, to pay off other
debts, 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.
In banking and finance, refinancing risk is the possibility that a borrower cannot refinance by borrowing to repay existing
debt. Many types of commercial lending incorporate
bullet payments at the point of final maturity; often, the intention or assumption is that the borrower take out a new loan to pay the existing lenders.
A borrower that cannot refinance its existing debt and does not have sufficient funds on hand to pay its lenders may have a
liquidity problem. It may be considered technically
insolvent: although its assets are greater than its liabilities, it cannot raise the liquid funds to pay its creditors. Insolvency may lead to
bankruptcy, despite the fact that the company has a positive
net worth.
Most large corporations and
banks face this risk to some degree, as they may constantly borrow and repay loans. In general, refinancing risk is only considered to be substantial in cases of
financial crisis, when borrowing funds may be extremely difficult.
Refinancing is also known as "rolling over" debt of various maturities, and may be referred to as rollover risk.