Debt Refinancing: A Comprehensive Guide to Lowering Your Payments

Debt refinancing is the replacement of an existing debt by means of another debt with terms and/or conditions that are more favorable. In other words, debt refinancing refers to the replacement of existing debt with new debt.

How It Works

Debt refinancing is commonly used to take advantage of new financing that offers more favorable terms and/or conditions. In such a situation, an individual or company will settle their current debt outstanding through issuing new debt with more favorable terms or conditions. The process is illustrated below:

The most common reasons to refinance debt are:

1. To take advantage of better interest rateInterest RateAn interest rate refers to the amount charged by a lender to a borrower for any form of debt given, generally expressed as a percentage of the principal. terms of the new debt;
2. To reduce the monthly repayment amount by entering into new debt with longer terms;
3. To switch from a variable-rate debt to a fixed-rate debt or vice versa (commonly done in changing interest rate environments).

Practical Example

An individual currently has $1,000,000 remaining on their mortgageMortgageA mortgage is a loan – provided by a mortgage lender or a bank – that enables an individual to purchase a home. While it’s possible to take out loans to cover the entire cost of a home, it’s more common to secure a loan for about 80% of the home’s value. for 20 years at 10%. In such a situation, the monthly installment payments (principal and interest) would be $9,650. The bank has indicated to the individual that they would be able to refinance to a 7% loan for 20 years due to a decrease in the bank’s interest rate.

As such, the monthly installment payments for the new mortgage would be $7,753. If the individual refinances their mortgage, they would be saving $1,897 ($9,650 – $7,753) in monthly installment payments.

Limitations to Refinancing Existing Debt

Although refinancing existing debt is an attractive option for borrowers, it may not be feasible in some cases. Debt may include call provisions so that a penalty payment is incurred to the borrower if they refinance the debt. In addition, there may be closing and/or transaction feesTransaction CostsTransaction costs are costs incurred that don’t accrue to any participant of the transaction. They are sunk costs resulting from economic trade in a market. In economics, the theory of transaction costs is based on the assumption that people are influenced by competitive self-interest. associated with refinancing existing debt.

As such, although an individual or company may have the option to secure better terms and/or conditions on their debt, it may not be ideal to do so when considering the penalty payment, closing fees, and/or transaction fees.

In the example above, refinancing the debt would save the individual approximately $455,280 over the life of the mortgage. If the penalty payment, closing fees, and/or transaction fees do not amount up to $455,280, the individual should refinance the debt. If the penalty payment, closing fees, and/or transaction fees exceed $455,280, it would not be in the best interest of the individual to refinance their debt.

Debt Refinancing vs. Debt Restructuring

The two terms are commonly used interchangeably. Readers should note that they are actually different.

To reiterate, debt refinancing is used to convey the replacement of existing debt with new debt that offers more favorable terms or conditions. On the other hand, debt restructuringDebt RestructuringDebt restructuring is a process wherein a company or other entity experiencing financial distress and liquidity problems refinances its existing debt obligations in order to gain more flexibility in the short term and to make its debt load more manageable overall. is used to describe the altering of existing debt. It can be in the form of delaying interest payments or extending the term of the debt. Debt restructuring is commonly used by a company that is approaching bankruptcy and needs to restructure its debt to stay afloat.

For example, in September 2018, Sears Holdings Corp. proposed restructuring the company’s debt to avoid bankruptcy. As such, debt restructuring was used to change the existing debt structure of a near-bankrupt company.

Additional Resources

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To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:

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• Senior and Subordinated DebtSenior and Subordinated DebtIn order to understand senior and subordinated debt, we must first review the capital stack. Capital stack ranks the priority of different sources of financing. Senior and subordinated debt refer to their rank in a company's capital stack.  In the event of a liquidation, senior debt is paid out first