Debt refinancing refers to the exercise of reorganising your debt by replacing your existing loan with a new one that offers you a lower interest rate, better equated monthly instalment (EMI) terms, and/or helps you reduce the tenure of your loan.
Interest rates are often the major motivating factor when it comes to refinancing loans. Whether you’ve taken an education loan for a Master’s degree abroad or a home loan that also helps you save on taxes, your loan will have either a fixed interest rate that remains the same throughout the loan period or a floating interest rate that changes based on market fluctuations. In a macro sense, there is also the repo rate — the interest rate at which the RBI lends to commercial banks — which has a trickle-down effect on the latter’s lending rates. According to Mint, as of 8 June 2023, the repo rate was 6.5%. The average repo rate over the past decade has been 5.5%.
There are two scenarios in which you might think about refinancing your loan. When the interest rate increases, banks increase the tenure of the loan by default. At this point, you can look for better options in terms of interest rates. Correspondingly, when the repo rate decreases, things are more straightforward — you can ask your lender to change the interest rate of your loan, and if they don’t, you can go for refinancing through another lender.
“If you have multiple loans to pay off, it is important to prioritise refinancing high-interest loans”
Refinancing your loan would involve taking stock of the terms of your loan agreement — mainly considering the interest rate — and then switching it for a better deal that’s out there. You can either switch to a more suitable loan provided by your current bank or lender, or transfer the loan to a new one. This has two benefits — one, your liability becomes easier or faster to pay off, and two, you can invest the money you save from refinancing. You could even use the amount you save to take a loan that helps you build another asset. In that sense, debt refinancing is good for both your liabilities and your assets.
Say you’re paying an EMI of ₹50,000 at the current interest rate. After refinancing, the interest rate reduces and your EMI comes to ₹42,000. This means that you will save ₹8,000 on a monthly basis — which you can invest in equities, mutual funds, or any other asset class.
There are some things to keep in mind when you’re considering refinancing your debt. Of course, checking and comparing interest rates comes first. This in turn informs another crucial factor — the cost of refinancing, which is the amount of money you save by refinancing your debt. You can know this by checking for a competitive interest rate. The processing fee differs from one lender to another, so choosing a lender that offers you a loan on favourable terms at an affordable cost is key. Anticipating the operational challenges that might arise during the documentation process, and the time and effort required for this, helps too.
It might also be useful to note that lenders usually prefer to refinance loans for things that increase in value over time — like education loans, home loans, etc. — as opposed to loans taken for depreciating assets, like a car loan, for instance. And importantly, banks determine the interest rate of a loan based on your credit score, which means that before refinancing a loan, you should ensure that your credit score is good. Frequent refinancing — which usually happens in case of credit card loans — can actually harm your credit score. Finally, if you have multiple loans to pay off, it is important to prioritise refinancing high-interest loans.