Uses and Advantages of Refinancing Debt
Refinancing may be undertaken to reduce interest costs (by refinancing at a lower rate), to pay off other debts, to reduce one's periodic payment obligations (sometimes by taking a longer-term loan), to reduce risk (such as by refinancing from a variable-rate to a fixed-rate loan), and/or to liquidate some or all of the equity that has accumulated in real property during the tenure of ownership.
In essence, refinancing a mortgage or other type of loan can lower the monthly payments owed on the loan either by changing the loan to a lower interest rate, or by extending the period of loan, so as to spread the re-payment out over a long period of time. The money saved can be used to pay down the principal of the loan, thus further reducing payments. Alternately, refinancing can be used to transform available equity in one's house into ready cash, available for other purposes or expenses.
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 prime rates used to calculate them. By refinancing an adjustable-rate mortgage or so-called "Balloon" mortgage into a fixed-rate one, the risk of interest rates increasing dramatically is removed, thus ensuring a steady interest rate over time.
Finally, 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. The net savings between the two interest rates can then be applied either towards further paying down the debt, or other purposes. In addition, non-tax deductable debt, such as credit card or car loan debt, can be transformed into tax-deductable debt such as home mortgage debt, potentially lowering one's taxes or shifting one into a more advantageous tax bracket.
Types of Refinance
Rate and Term Refinance
This type of refinance refers to a change in the rate and term of an existing loan. A refinance is considered rate and term if the borrower secures a lower interest rate, or changes the terms of a loan to ensure a longer fixed period or a lower payment plan, without paying off any additional debts or taking any cash in hand.
Cash-Out Refinance
A refinance is considered cash-out when a borrower pays off other debts or advances money on top of their existing loan amount, while also changing the rate and term of the existing loan. It differs from a rate and term loan because the new loan amount is larger than the existing loan amount due to the additional cash taken with the new loan. If a borrower pays off credit cards or unrelated loans, or opens an equity line behind an existing mortgage, the new loan will be considered cash-out.
