What Is Refinancing, and How Does it Work?

Ideally, refinancing an existing loan should create a better financial circumstance for you and your business. If you have a debt you’re thinking of refinancing, it’s important to first understand how the process works.

This article is for educational purposes and does not constitute legal, financial, or tax advice. For specific advice applicable to your business, please contact a professional.

When you have a debt, like a mortgage or business loan, the financing terms, such as the interest rate and repayment timeline, are set. It’s possible, however, to change them with a refinance, which replaces an existing loan with a new one. Once you apply, are approved, and complete the closing, the old debt is paid off and a new loan and contract is established.

Ideally, refinancing an existing loan should create a better financial circumstance for you and your business. If you have a debt you’re thinking of refinancing, it’s important to first understand how the process works.

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How Does Refinancing Work?

Borrowers may choose to refinance a loan for many reasons, but one of the most common is in an attempt to improve the loan’s interest rate. During the pandemic, mortgage rates hit record lows and interest on personal loans also recorded all-time lows. If your current loan was put in place more than a year or two ago, you might be able to lower your interest with a refinance. You may also be able to qualify for a lower interest rate if your credit score has improved or if your business revenue has increased since the loan was originated.

Why Do Business Owners Refinance?

Another reason to refinance is to change the rate on your loan from variable to fixed. With a variable-rate loan, interest can fluctuate according to the market, causing your monthly payments to fluctuate, too. Since interest rates are low, it might make sense to lock it in with a new fixed-rate loan, which is a loan with an interest rate that doesn’t change during the entire term. Not only will you take advantage of the current economic climate, but you will also have a predictable monthly payment.

If you have cash flow challenges, refinancing an existing loan could result in a lower payment that works better with your budget. By getting a lower interest rate or changing the terms and stretching the repayment over a longer period of time, a reduced monthly bill could free up funds you can use for other expenses or investments in your business.

If you have several outstanding loans, you can consolidate them into one new loan instead of refinancing each debt separately. Combining the balances could reduce your monthly payment and shorten your repayment period. You may also be able to reduce the total amount of interest paid, especially if you have high-interest loans, such as credit cards.

Which Loans Can Be Refinanced?

Just about any debt can be refinanced. Mortgages are a popular type of loan for refinancing. In fact, compared with March 2019, Canadian homeowners seeking a mortgage refinance rose 156% in March 2020.

Business loans can be refinanced, too, including working capital loans, equipment loans, term loans, or commercial real estate loans. You can learn more about small business loans and refinancing with the Canada Small Business Financing Program.

Personal loans, student loans, and auto loans are also eligible for refinancing. If you choose to refinance the loan with a private lender, you will remove some of the benefits the government offers borrowers, such as potential debt cancellation.

How Do I Qualify for Refinancing?

If you are considering refinancing a current loan, you’ll need to meet the same qualifications that were required for the original loan. Different lenders will have different qualifications, and it’s a good idea to know what’s required before you apply. Check your current loan balance and interest rate to make sure refinancing makes sense. Then determine how much you want to borrow and the rates that are currently available.

Refinancing includes fees, so you need to ensure that the potential savings are greater than the costs of obtaining the new loan. Resources, such as a refinance calculator, can help you determine if refinancing is right for you. Depending on the type of loan, you may be charged these types of fees, according to RateHub:

  • Prepayment penalty
  • Discharge fee
  • Registration fee
  • Legal fees

Next, gather the information needed for the application. Lenders will pull both your personal and business credit scores. They’ll want to know: your debt utilization ratio, type and length of existing debt, length in business, and income history. You’ll also be asked to provide documentation, including:

  • Tax returns
  • Accounts payable
  • Bank statements
  • Balance sheet
  • Profit and loss statement
  • Business plan

You could refinance your loan with the same bank or find a new financial institution, but make sure to compare interest rates, terms, and fees from multiple lender options. It’s also important to only pre-qualify with lenders that perform soft credit pulls, which don’t impact your credit score.

What Are the Pros and Cons of Refinancing a Loan?

Pros Cons
Lower rates can reduce your monthly payments and the total amount of interest paid over the term of the loan. Applying for a refinance will generate a hard inquiry on your credit report, negatively impacting your credit score.
A lower payment can improve your monthly cash flow The existing debt may have prepayment penalties.
Refinancing provides an opportunity to increase the amount of funding to add working capital. The fees could outweigh savings, making the new loan more expensive than the existing loan.
Improving your debt utilization ratio can help boost your credit score Extending the length of the loan could result in paying more interest.

Making the Best Decision for You

While refinancing loans can help you pay off existing balances faster, it’s not always the right choice. Carefully weigh the pros and cons, do the math to make sure refinancing makes financial sense, and shop around for the best terms and rates. Making informed decisions will support the long-term growth and stability of your business — and in some cases, refinancing can be a key part of your growth strategy.