Refinancing

A borrower who took a home loan when rates were high is not stuck with that rate for twenty years. They can take a new loan from another lender at a lower rate and use it to repay the old one.

That is refinancing: repaying an existing loan by taking another loan, either to extend the duration of the loan or to lower the interest cost. The reason for doing it is usually a lower rate on the new loan, which reduces the overall outgo.

The workbook notes that refinancing is usually done for long-term loans or loans with a high outstanding amount, because that is where the interest saving is large enough to matter. Its example is refinancing a home loan when the gap between the borrower's existing rate and the new available rate is significant.

In debt re-scheduling (4.3.4). If the cost of debt is high, cheaper re-financing is an option — a lower cost loan is availed to repay the costlier loan. A credit card balance transfer is the workbook's example of such refinancing.

What eats into the saving (4.12). When comparing loans the workbook lists:

• the interest rate, and whether it is calculated on a reducing balance method;
• the reset period for interest rate changes;
• processing fees and legal or other charges, a percentage of the loan or a fixed sum, which add to the cost — though they are sometimes waived;
• the tenure offered — longer tenure means lower EMI but higher total interest;
• the benchmark — external benchmarks such as the repo rate are transparent and transmit changes faster than internal bank benchmarks.

Extending tenure is a different trade. Refinancing to a longer tenure reduces the monthly outgo, but the loan is repaid over a longer period and total interest goes up — the workbook says this explicitly about extending tenure.

Present value check (4.10). For any change to a loan's terms, the workbook's test is the present value of all future payments: a lower EMI over more months is not automatically a saving.

Illustrative figures.

Mr Srinivasan has Rs 40,00,000 outstanding on a home loan at 9.5%, with 15 years (180 EMIs) left. Another bank offers 8.5% for the same 15 years, with a processing fee of 0.5%.

Net of the fee, the switch saves roughly Rs 4,08,000 in payments over the tenure, and the fee is recovered in about nine months. This is the workbook's case for refinancing: a long-term loan, a high outstanding balance, a significant rate gap.

Now the trap. The new bank also offers to stretch the tenure to 20 years at 8.5%, cutting the EMI further. That lowers the monthly outgo but adds five more years of interest. If the goal is to cut cost, keep the tenure; stretch it only if the EMI itself is the problem.

The same logic in miniature: a Rs 1,00,000 credit card balance at 3% a month moved to a balance-transfer offer at a much lower rate is refinancing too — and, at 42.6% a year, usually the most valuable refinancing a household can do.

Chapter 4 (Debt Management and Loans): 4.7.7 defines refinancing; 4.3.4 lists it among the debt re-scheduling options with the balance-transfer example; 4.12 gives the criteria for evaluating a loan; 4.10 applies present value to changed loan terms. Expect a definition question and an identification question (a card balance transfer is an example of what?).

• Refinancing replaces a loan; prepayment reduces it. Refinancing uses new borrowed money.
• A credit card balance transfer is refinancing in the workbook's own words.
• Longer tenure lowers the EMI and raises total interest. Do not call that a saving.
• Processing and legal charges add to the cost of the new loan.
• It pays most on long-term, high-outstanding loans where the rate gap is significant.
• Check the workbook's restructuring arithmetic before trusting it. In 4.10 the 3-year Rs 3 lakh loan at 7% has an EMI of Rs 9,263, but the text later says a cut to 5% makes the EMI drop "from Rs 9,253 to Rs 5,994". At 5% the EMI on Rs 3 lakh over 36 months is about Rs 8,991; Rs 5,994 is the 5% EMI on the Rs 2 lakh haircut amount. If a question reproduces those figures, follow the options offered, but know the correct arithmetic.