From Wikipedia, the free encyclopedia
|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
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.
One of the most important decisions a homeowner will have to make when deciding to re-finance their home is whether they want to refinance with a fixed mortgage, an adjustable rate mortgage (ARM) or a hybrid loan which combines the two options.
The names are pretty much self explanatory but basically a fixed rate mortgage is a mortgage where the interest rate remains constant and an ARM is a mortgage where the interest rate varies.
The amount the interest rate varies is usually tied to an index such as the prime index.
Additionally there are usually clauses which prevent the interest rate from rising or dropping dramatically during a specific period of time.
This safety clause provides protection for both the homeowner and the lender.
Advantages of a Fixed Option:
A fixed re-financing option is ideal for homeowners with good credit who are able to lock in a favourable interest rate. For these homeowners the interest rate they are able to retain makes it worthwhile for the homeowner to re-finance at the new interest rate. The major advantage to this type of re-financing options is stability.
Homeowners who re-finance with a fixed mortgage rate do not have to be concerned about how their payments may vary during the course of the loan period.
Disadvantages of a Fixed Option:
Although the ability to lock in a favourable interest rate is an advantage it can also be considered a disadvantage. This is because homeowners who re-finance to obtain a favourable interest rate will not be able to take advantage of subsequent interest rate drops unless they re-finance again in the future. This will result in the homeowner incurring additional closing costs when they re-finance again.
Advantages of an ARM Option:
An ARM re-finance option is favourable in situations where the interest rate is expected to drop in the near future. Homeowners who are skilled at predicting trends in the economy and interest rates may consider re-financing with an ARM if they expect the rates to drop during the course of the loan period. However, interest rates are tied to a number of different factors and may rise unexpectedly at any time despite the predictions by industry experts.
A homeowner who can predict the future would be able to determine whether or not an ARM is the best re-financing option. However, since this is not possible homeowners have to either rely on their instincts and hope for the best or select a less risky option such as a fixed interest rate.
Disadvantages of an ARM Option:
The most obvious disadvantage to an ARM re-financing option is that the interest rate may rise significantly and unexpectedly. In these situations the homeowner may suddenly find themselves paying significantly more each month to compensate for the higher interest rates.
While this is a disadvantage, there are some elements of protection for both the homeowner and the lender. This often comes in the form of a clause in the terms of the contract which prevents the interest rate from being raised or lowered by a certain percentage over a specific period of time.
Consider a Hybrid Re-Financing Option:
Homeowners who are undecided and find certain aspects of fixed rate mortgages as well as certain aspects of ARMs to be appealing might consider a hybrid re-financing option. A hybrid loans is one which combines both fixed interest rates and adjustable interest rates.
This is often done by offering a fixed interest rate for an introductory period and then converting the mortgage to an ARM. In this option, lenders typically offer introductory interest rates which are extremely enticing to encourage homeowners to choose this option.
A hybrid loan may also work in the opposite way by offering an ARM for a certain amount of time and then converting the mortgage to a fixed rate mortgage. This version can be quite risky as the homeowner may find the interest rates at the conclusion of the introductory period are not favourable to the homeowner.
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