Refinance: What it is and How it Works

Key Takeaways

• A refinance is the process of modifying and supplanting the terms of an existing credit agreement.

• Refinancing goals are often to reduce one’s fixed-interest rate to lower payments over the loan’s life, to alter the loan’s duration, or to change from an adjustable-rate mortgage to a fixed-rate mortgage, or the other way around.

• Some business investors assess businesses’ balance sheet for business loans that could benefit from better credit or lower market rate.

Perhaps an investor seeks a better interest rate on their rental property, modification of loan terms, and conversion of accrued equity into cash. That calls for a refinance, commonly known as a “refi.” But what is refinancing all about? Here is that and more, including how alternative investments can provide steady passive income.

What is Refinance?

A refinance is the process of modifying and supplanting the terms of an existing credit agreement.

It is usually used in relation to a mortgage or loan, and often for car loans and student loans as well. Companies also seek to refi mortgage loans on commercial properties, and some business investors assess business’ balance sheets for business loans that could benefit from better credit or lower market rate.

A person or company that pursues a refi essentially seeks to have their rate, payment schedule, or other terms changed. The new contract, pending approval, replaces the original agreement.

Timing-wise, borrowers frequently opt for refinance when the interest-rate milieu changes markedly, resulting in prospective savings on debt payment from a new contract.      

How Does a Refinance Work?

Commonly, those who wish to refinance a debt usually do so to gain more favorable terms, frequently to counter changing economic conditions. Refinancing goals are often to reduce one’s fixed-interest rate to lower payments over the loan’s life, to alter the loan’s duration, or to change from an adjustable-rate mortgage to a fixed-rate mortgage, or the other way around.

Other reasons borrowers may refinance include an improved credit standing, changes in personal circumstances that have changed long-term financial plans, and to consolidate debts into a single loan.

Most commonly, it is the interest rate environment that is the motivation for refinancing. In other words, many people and businesses opt to refinance when rates decrease. Interest rates are cyclical, with influencing factors including the economic cycle and national monetary policy. Such factors can affect the interest rates of loans and revolving cards, so those who have debt on variable-interest-rate products wind up paying out more in interest. In a decreasing-rate environment, the opposite is true.

To refinance, a borrower must complete a loan application at their existing banking institution or a new one, a process in which the applicant’s financial situation and credit terms are re-evaluated.

The Pros and Cons of Refinancing

As with most anything in the finance and investing space, there are pros and cons to refinancing.

Possible Benefits

• Lower monthly payments. Refinancing can lower the loan principal, which can lower the monthly payment.
• Lower interest rate. When interest rates fall, many people consider refinancing to take advantage. 
• A fixed rate. Protection from future interest rate increases comes with locking in a fixed rate. If one’s original loan is an adjustable-rate mortgage, that can be switched to a fixed rate.
• A shortened loan term. For those who can handle an increased monthly payment, they can use a refi to shorten their loan term, potentially saving them a lot of money over the loan’s life.
• Access a large sum of cash without selling the home. A cash-out refinance can be used as an alternative to a home equity loan. Note, though, that the cash taken out will cost more in interest over the new loan’s life, but not necessarily more than what other financing options would cost.

Possible Drawbacks

• A longer-term loan could cost. Getting a mortgage with a lower interest rate can save the borrower money every month. Still, it pays for the borrower to consider the loan’s overall cost since they could end up paying more in interest overall and have additional years of mortgage payments.
• The borrower may not ultimately save. If it takes three years to get back refi expenses, and a move is scheduled for within two years, the borrower will not save money. Thus, it is key for a homeowner to use a mortgage calculator to establish how much a refinance will cost and how much will be saved monthly.
• Ignoring refi costs can be costly. While lowering one’s monthly payment while reducing their interest rate can be financially advantageous, pay attention to potential closing costs and fees in addition to additional mortgage payments if loan terms are extended.

Types of Refinance

There are a number of types of refinancing, including:

• Rate-and-term. The most common type of refi, rate-and-term is when the original loan is paid and supplanted with a new agreement with lower interest payments.
• Cash-out. These are most common when the value of the underlying asset that secures the loan has increased.
• Cash-in.  This permits the borrower to pay down a part of the loan for smaller loan payments or reduced loan-to-value ratio.
• Consolidation. This can be utilized when an investor gains a single loan at a lower rate than the existing average rate across credit products such as credit cards or loans.

Refinance Examples

Say Bonnie and Christopher have a 30-year-fixed-rate mortgage and their 8% interest rate was locked in a decade ago. Because interest rates have fallen, they contacted their bank and were able to refinance their mortgage at a new, lower rate of 4% for the next 20 years while reducing their interest rate payment. They may be able to reduce their interest rate further in the future should interest rates fall again. 

A business might seek refinancing to improve their financial position and may involve calling in older issues of corporate bonds and issuing new ones at reduced interest rates.

Improving One’s Position Through Alternatives

One possible benefit of refinancing is an influx of cash to be used however the person wishes. Meanwhile, investments in alternatives – basically any assets other than stocks and bonds – are increasingly popular for potential benefits including steady passive income.

Because of their low correlation to public markets, alternative assets such as art and real estate can decrease portfolio volatility. They also can potentially improve returns, offer tax favorability, and shield against inflation and other economic downturns. After all, private markets — including real estate, transportation, venture capital and more — have historically performed  better than stocks in every downturn over the last 15 years.

The alternative investment platform Yieldstreet, on which nearly $4 billion has been invested, offers highly vetted opportunities and the broadest available selection of alternative asset classes, including art, which has performed better than the S&P 500 since 2000, returning more than 360%.

To date, Yieldstreet’s art offerings, which include fractional ownership, have provided a net annualized return of 12.2% on an entry minimum as low as $10,000. Through art equity funds, investors can access, with a single investment, a pool of artwork by blue-chip, mid-career, and emerging artists.

Yieldstreet uses third-party expertise and appraisals, complemented by analyses from a proprietary database managed by wholly owned Yieldstreet subsidiary Athena Art Finance, which has funded more than $400 million in fine art investments. Thus, investors need not do the due diligence they otherwise would if investing in art on their own.

Portfolio Diversification and Alternative Investments

Investment in art, as with all alternative investments, also serve another crucial purpose, and that is diversification – the spreading of investments among, as well as within, varying asset classes. Diversified holdings can reduce overall portfolio risk. In fact, diversification is key to long-term investing success.

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10,000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

For more favorable borrowing terms, refinancing may be a viable option when interest rates drop, potential drawbacks notwithstanding. It is important for investors, homeowners, and businesses to carefully weigh all factors to make sure refi is the appropriate move.