Refinancing

Refinancing is settling an existing loan by taking out a new one, usually on different terms. The old debt is discharged, a new agreement replaces it, and the borrower continues with a different rate, term, instalment, lender or security arrangement.

The word covers two situations that could hardly be more different, and conflating them causes real damage — to borrowers who think they are saving money, and to lenders whose portfolio metrics quietly stop describing reality.

Commercial refinancing happens when a borrower who is perfectly able to pay chooses to pay differently. Rates have fallen, their credit standing has improved, a competitor has made a better offer, or they want to release equity. The loan was performing and continues to perform.

Distressed refinancing happens when a borrower who cannot meet the existing terms is given new ones they can meet. Nothing about their capacity has improved. The loan was in difficulty and remains in difficulty, wearing a new agreement.

The arithmetic, the accounting, the classification and the provisioning of these two are not the same, and treating the second as though it were the first is one of the more consequential errors a lender can make.

Refinancing and its neighbours

• Refinancing: Old loan settled by a new one. Borrower is able to pay and choosing better terms. Accounting: New loan booked, old loan closed.
• Restructuring: Existing loan terms varied (term extended, rate cut, payments deferred) because the borrower cannot meet original terms. Accounting: Same loan modified; distressed classification is usually retained.
• Rescheduling: Repayment dates changed with principal unchanged due to a temporary cash flow problem. Accounting: Same loan modified.
• Rollover: Loan extended at maturity rather than repaid because the bullet cannot be repaid. Accounting: Same exposure extended.
• Top-up: Additional amount added to an existing loan for a borrower who is usually able to pay. Accounting: Increased exposure, often re-documented.
• Consolidation: Several loans settled by one new loan to manage multiple obligations. Accounting: New loan booked, several existing loans closed.
• Evergreening: Repeated rolling or increasing to cover interest falling due when effectively in default. Accounting: Should be classified as impaired.

The line that matters most is between refinancing and restructuring, because it determines whether the arrears clock resets.

A distressed borrower whose loan is restructured has not cured. Their arrears history does not vanish because the paperwork changed. Most supervisory frameworks require restructured exposures to retain their classification, or to serve a defined performance period under the new terms before any upgrade, precisely so that a modification cannot be used to convert a non-performing loan into a current one overnight. The specific cure periods and classification rules vary by jurisdiction — confirm the current requirements locally.

Where a lender books a distressed restructure as a fresh loan, three things happen at once: portfolio at risk falls without anything improving, loan loss provisioning is released that should have been held, and the collections team stops working a file that needed working. The problem does not go away. It goes quiet, and it comes back larger.

Why borrowers refinance

• A lower rate, because market rates fell or their own credit standing improved
• A lower instalment, usually by extending the term
• Releasing equity from an asset that has appreciated or amortised
• Consolidating several obligations into one payment
• Changing lender, for service, speed or relationship reasons
• Changing structure — moving from a revolving facility to a term loan, or from variable to fixed pricing
• Removing a party, since a co-borrower cannot otherwise be released from liability
• Changing currency, which swaps interest rate exposure for exchange rate exposure and is rarely the bargain it appears

Worked example: does the refinance pay for itself?

An existing loan has 200,000 outstanding with 24 months remaining at 3% per month, giving an instalment of 11,809. A competing lender offers 200,000 over 24 months at 2.2% per month, an instalment of 10,814.

Monthly cash flow:

• Current instalment: 11,809
• New instalment: 10,814
• Monthly saving: 995

Upfront refinancing costs:

• Arrangement fee (2% of 200,000): 4,000
• Legal and valuation costs: 3,000
• Early settlement penalty (2%): 4,000
• Total cost of refinancing: 11,000

Break-even = 11,000 ÷ 995 ≈ 11 months

With 24 months remaining, the borrower is ahead from month twelve onward and saves roughly 12,900 over the remaining term. The refinance is worth doing.

The rule this produces is simple: if the remaining term is shorter than the break-even period, refinancing loses money no matter how much better the headline rate looks. A borrower with eight months left on the same loan would pay 11,000 to save 7,960.

The term extension trap

The most common form of refinancing lowers the instalment by lengthening the term. It reliably increases the total cost, and it does so in a way that is invisible in the only number most borrowers look at.

Same 200,000 balance at 3% per month:

Option A: Keep 24 months

• Monthly instalment: 11,809
• Number of payments: 24
• Total repaid: 283,416
• Total interest: 83,416

Option B: Extend to 48 months

• Monthly instalment: 7,916
• Number of payments: 48
• Total repaid: 379,968
• Total interest: 179,968

The instalment falls by a third. The interest paid more than doubles — an additional 96,552, or roughly half the original balance again.

This is not an argument against ever extending a term. A borrower whose alternative is default is unambiguously better off making smaller payments for longer, and lenders should offer that. It is an argument against presenting a lower instalment as a saving. The instalment measures affordability; the total repaid measures cost. Any refinancing discussion that quotes only the first is incomplete, and in several jurisdictions disclosing only the first is a regulatory breach.

Early settlement: the figure that decides everything

A refinance requires the existing loan to be settled, and the settlement figure is frequently far higher than the borrower expects.

On reducing-balance loans, settlement is straightforward: the outstanding principal, plus accrued interest to the settlement date, plus any prepayment penalty. Interest that has not accrued is not charged, so early settlement genuinely saves money.

On flat-rate loans, it usually does not. Interest on a flat-rate loan is calculated on the original principal for the full term and added at the outset. Where the contract provides no rebate — or a rebate calculated on a front-loaded basis such as the Rule of 78 — settling early does not proportionally reduce the interest owed.

A loan of 100,000 at 20% flat over 24 months:

• Principal: 100,000
• Total interest (20% flat × 2 years): 40,000
• Total payable: 140,000
• Monthly instalment: 5,833
• Paid after 12 months: 70,000
• Settlement figure with no rebate: 70,000

The borrower has had the money for one year and paid the full two years' interest. Their effective annual cost is close to double the headline 20%, and there is no interest saving to fund a refinance. The same borrower on a reducing-balance loan would owe substantially less at the same point and would save real money by settling.

Three practical consequences. Borrowers should obtain a written settlement figure before agreeing to any refinance, not estimate it from the balance. Lenders quoting flat rates should expect — and in many markets are required to disclose — the effective reducing-balance equivalent. And any comparison between a flat-rate loan and a reducing-balance offer is meaningless until both are converted to the same basis.

Refinancing from the lender's side

Taking a refinance in brings a customer with a demonstrated repayment record, which is better evidence than any credit scoring model produces for a stranger. The question worth asking is why they are leaving. A borrower shopping on price is one thing; a borrower whose existing lender has declined a top-up, tightened their limit or started asking questions is another. Adverse selection in refinancing is real and the bureau report is where it shows up.

Losing a refinance out costs the future margin on a loan that was performing, which is the definition of losing your best customers. It also produces prepayment risk on books funded with matched-term liabilities.

Internal refinancing and top-ups are the most useful and most dangerous tool here. Used well, a top-up for a borrower on their fifth clean cycle is retention, reward and growth in one transaction. Used badly, a top-up that settles arrears and capitalises unpaid interest converts a delinquent account into a current one on paper while increasing the exposure. The distinction is entirely about the borrower's capacity, and it should be documented in the file:

• Is the borrower current, and were they current before this transaction?
• Does fresh loan appraisal support the new, larger obligation?
• Are arrears or accrued interest being capitalised into the new principal?
• Would this borrower be approved today as a new applicant on these terms?

If the answer to the last question is no, the transaction is a restructure and should be classified as one.

Serial refinancing

Each cycle capitalises arrears, adds fees and extends the term. The balance rises, the borrower's position weakens, and the file looks current throughout.

A borrower refinanced three times in eighteen months is not a good customer. They are a distressed exposure with a clean payment record, and the payment record exists only because each refinance settled the previous one. Counting refinances per borrower over a rolling window is a cheap and effective control, and very few lenders run it.

Operational mechanics

Settle the outgoing lender directly. Funds released to the borrower to settle another loan are frequently used for something else, leaving two live debts where there should be one.

Obtain a written settlement figure with a validity date. Settlement amounts change daily, and a figure that expires before disbursement leaves a shortfall.

Sequence the security. Discharge of the outgoing lender's charge and registration of the new one must be handled so there is no window in which the new lender has advanced funds without a registered interest. In practice this means undertakings between the parties rather than trust.

Confirm the old facility is closed. Particularly for revolving facilities and credit cards — a consolidation that pays down balances without closing the accounts frequently ends with the borrower carrying both the consolidation loan and freshly redrawn revolving debt.

Re-run affordability on the new terms. The obligation being replaced is not the obligation being created.

Where refinancing goes wrong

Distressed restructures booked as new loans. Understates arrears, releases provisions that should be held, and stops the collections process.

Only the instalment disclosed. A term extension presented as a saving.

Break-even never calculated. Fees and penalties exceeding the interest saved over the remaining term.

Flat-rate settlement misunderstood. Borrower and officer both assuming early settlement will produce an interest rebate that the contract does not provide.

Consolidation without closing accounts. Revolving balances redrawn, leaving the borrower with more total debt than before.

Arrears capitalised silently. Unpaid interest folded into principal, so the borrower now pays interest on interest and the file shows no history of difficulty.

No limit on refinance frequency. Serial refinancing continues until the exposure is too large to restructure again.

Security gap at changeover. Funds advanced before the new charge is registered, leaving the loan unsecured during the window.