Refinancing your loans: Why it matters

In this ever dynamic world, change is the only constant. That is just as applicable to the financial world, even more so in modern times. From changes in interest rates, fluctuations in asset values, volatility in business profitability, the macro and micro economic environment is constantly changing. But it’s not always a bad thing – you can actually stand to benefit from these changes.

One of the key tools at your disposal to leverage the market changes to your financial benefit is refinancing. Imagine, a home loan taken 5 years ago would be at the then prevailing interest rate (assuming it is a fixed rate loan) and be appropriate for our cash flow and assets back then. Refinancing, if done right, helps to leverage changes in our finances or interest rates positively to help save money and time.

What is refinancing?

Refinancing means, replacing your old loan with a new loan. This new loan amount pays off the outstanding amount of the old loan. People generally consider refinancing for the following purposes:

  • Leverage on lower interest rates
  • Reduce loan tenure
  • Change loan type
  • Consolidate debt

The intent of the exercise is to improve the overall terms of the loan and benefit from interest cost saved. Let us see how each of the above factors can be used for refinancing.

refinancing loan

Benefits of refinancing

Leverage on lower interest rates

If the current interest rates are lower than the original loan interest rates, refinancing is the easiest way to reduce your interest burden. Since interest rates directly determine the total interest cost and loan duration, even small changes in the interest rates can have significant changes to your overall interest payment in the long term. Let us look at an example:

  • Loan amount: Rs 50,00,000
  • Old loan interest rate: 8%
  • New loan interest rate: 7%
  • Refinancing benefits:
    • Interest cost saved: Rs 18,03,099 
    • Loan paid off earlier by: 3 years and 8 months
Loan Outstanding amount 1

Reduce loan tenure

If your salary and surplus has increased since you got the original loan, you might have the bandwidth to afford a larger equated monthly installment (EMI). Most loans do not allow you to make internal changes to the agreed upon EMI structure and charge a penalty for lump sum prepayment as well. In this case, you can reduce your overall interest cost payment by refinancing to a loan option with a higher EMI payment and shorter duration. Let’s put this in perspective with an example:

  • Outstanding loan amount: Rs 50,00,000
  • Under original loan structure, 
    • Remaining loan tenure: 20 years
    • EMI: Rs 42,000
  • After refinancing,
    • New loan tenure: 15 years
    • EMI: Rs 48,000
  • Refinancing benefits:
    • Interest cost saved: Rs 14,27,040
    • Loan paid off earlier by: 5 years
Loan Outstanding amount 2

Change loan type

This is usually done when someone has a variable rate loan and wants to change it to fixed rate type. A variable rate loan is usually considered riskier as we are left exposed to changes in interest rates. Hence, in a low interest rate environment, it might make sense to refinance to a fixed rate loan and have that rate locked in instead of being variable.

Consolidate debt

Consolidation of loans into a single loan is sometimes beneficial to reduce the interest on high interest loans and efficiently manage the repayment as only one loan needs to be paid up.

Other considerations

Transactional cost

Refinancing usually involves transactional costs. These need to be factored in, to calculate the net benefit of refinancing. If there is an overall gain after the transactional costs, it makes sense to proceed.

Adverse refinancing

When the refinancing transaction is carried out without considering the gains or losses, it can be counterproductive. For example, refinancing to a variable interest rate could lead to losses in the future if the interest rates rise. Knowledge of the interest rate environment is crucial in making such decisions and being prepared for the impact.

Bottom Line

Refinancing is an often ignored financial tool at our disposal. If we focus on the cost of our insurance policy or the returns on our investments to ensure that we come out financially ahead, why should we ignore the third pillar of our finances? Assessing refinancing opportunities on a regular basis can have a major impact on our overall interest costs – which often form a considerable portion of our expenses. These savings, as seen from the examples above, can put us in an advantageous position to achieve our goals.

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