Refinance: Definition, How It Works, Types, and Example

Do you have a credit line but are finding it difficult to repay the EMIs on time? Loan refinancing might help. A loan refinance usually proves to be more advantageous than the original terms. However, the aspiring borrower must research and plan before going for the option. It is the process of repaying the current debt with a new finance product at lower interest rates, a more convenient repayment schedule, and consolidating multiple payments into one. 

The following sections will discuss what refinancing is, its pros and cons, types, and examples.

What is a Refinance?

A refinance loan refers to the process of replacing the existing loan with a new credit agreement. When borrowers decide to refinance their credit obligation, they seek more favourable interest rates, repayment terms, and other conditions outlined in the current contract. Once approved, they get a new agreement in place of the original contract. Borrowers often refinance their loans when the interest rates change substantially, or they find the current loan's repayment challenging due to high interest rates or unsuitable terms and conditions.

How Does Refinancing Work?

The primary aim of a refinance loan is to benefit from a new finance option offering more favourable rates, terms, and conditions. When this happens, the borrower settles their current debt with a new debt with more favourable terms. It works by offering better interest rates on the new debt, reducing monthly EMIs with longer terms, or switching fixed-rate to variable-rate loans or vice versa.

To refinance an existing loan, the borrower approaches a new lender to apply for a loan. The lending institution assesses the borrower's financial situation and credit terms and approves the loan. The borrower uses funds from the new loan to pay off their existing loan or loans and gets a new loan with revised terms and conditions. Lower interest rates are the most common motivation for a refinance loan.

Also Read: 6 Things You Should Know Before Refinancing Your Business Loan

Types of Refinancing

Loan refinancing can be of four main types, including the following:

1. Rate-and-Term Refinancing

Rate-and-term refinancing is the most common type of refinance loan. It occurs when the borrower pays off the original loan with a new loan at lower interest rates.

2. Cash-out Refinancing

Cash-out is a common refinancing option when the collateral’s value increases. The borrower withdraws the asset’s equity or value and exchanges it with a higher loan amount. It allows the borrower to access immediate cash while retaining the asset's ownership.

3. Cash-in Refinancing

Cash-in refinancing allows a borrower to repay some portion of the loan for a lower LTV ratio or small EMIs. It refinances the debt by reducing the loan balance to cover the shortfall. It is an excellent funding option for those seeking a better loan deal at lower interest costs.

4. Consolidation Refinancing

Consolidating refinancing, or debt consolidation, involves refinancing multiple loans into a single monthly payment. Borrowers looking to simplify their repayment often opt for this approach, as it saves them from keeping track of numerous repayments to various lenders. 

Also Read: How To Repay Business Loan If Business Is Incurring Losses

Pros and Cons of Refinancing

Let’s look into the pros and cons of loan refinancing:

Pros	Cons
An excellent opportunity to reduce the interest rate and mortgage repayment.	If the loan term remains the same, the interest cost may outweigh the amount of savings through a lower rate.
Converts variable interest rate to fixed interest rate, providing the benefit of predictability and increasing savings.	If the interest rate of a variable rate loan drops, the borrower cannot benefit due to the fixed rate loan.
Provides immediate cash influx for urgent financial needs.	Sometimes, refinance may reduce the value their asset holds.
Shortens the loan term to save more money on the interest outgo.	Shortening the loan term may increase the monthly EMI amount, apart from the preclosure costs paid for the refinance.

Also Read: Managing Debt: Strategies For Repaying Your Business Loan

Examples of Refinancing

After understanding the refinance loan meaning, it’s time to look into a few examples of loan refinance.

1. Mortgage Refinancing

Alka takes a mortgage loan of Rs 20 Lakh based on the current value of her property. If the value of her property increases during the tenure, she can borrow a bigger loan amount against the asset. She can repay the current loan with her new loan and use the remaining amount for other financial needs.

2. Auto Loan Refinancing

Imagine that Mohit is currently paying an auto loan with Rs 25,000 EMI. He switches his job and receives a higher salary. Now, he can afford a bigger EMI to repay the loan earlier. He can approach a lender to refinance the loan at a shorter tenure, increasing the EMI.

3. Student Loan Refinancing

If Rahul takes a 20-year student loan at a fixed interest rate of 18%, the interest rate may drop due to economic conditions. He may reach out to their lender and refinance the existing loan at a reduced rate of 14%. This allows him to lock in a new interest rate for the remaining tenure, lowering his regular EMI payment.

4. Credit Card or Personal Loan Refinancing

Suppose Subhash has a credit card or Personal Loan but is unsatisfied with the company's customer service. In that case, he may refinance the card or loan with a new company with a better reputation and no hidden charges. Doing that will give him peace of mind and help him maintain a good relationship with the new company.

Also Read: How To Manage Your Personal Loan More Effectively

Conclusion

Now that what is refinancing a loan is clear, remember that it is a great way to improve your financial position. The biggest benefit for borrowers will be lower interest rates and suitable terms and conditions. That said, one must consider regular reviews to attain peace of mind and achieve the desired savings. At Hero FinCorp, both salaried and self-employed individuals can a refinance their existing loans or take a Personal Loan at interest rate for debt consolidation and make the repayments of their multiple debts manageable. 

Frequently Asked Questions

1. Is loan refinancing the same as debt restructuring?

Borrowers often use debt refinancing and debt restructuring interchangeably. However, they are different. Debt refinancing means replacing the current debt with a new one with more favourable terms and conditions. Conversely, debt restructuring involves changing the existing loan’s terms and conditions. It includes extending the repayment tenure or delaying interest payments. 

2. When should one consider refinancing their debt?

Borrowers may use a refinance loan if they find a new lender offering lower rates and better terms and conditions. The ideal time to refinance a loan is during the initial period of the repayment tenure. If they have already paid a significant portion of the loan, their benefit from refinancing will be negligible.

3. Does refinancing hurt credit?

When a borrower applies for a refinance loan, the lenders conduct a credit check that reduces their credit score due to a hard enquiry. However, this impact is temporary and the score adjusts over time. With regular payments, one can actually improve their credit score with more favourable terms and conditions. 

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