What Is Refinancing Risk?
Refinancing risk is the possibility that an individual or a company won't be able to replace a current debt obligation, such as a loan or a maturing bond issue, with a suitable new one at a critical point in the future. Factors that are beyond the borrower's control, such as rising interest rates or a shrinking credit market, often make it difficult to refinance a debt. Any decline in their creditworthiness can also be a factor. Refinancing risk can be mitigated to some degree by planning ahead for it and not borrowing more than necessary.
Key Takeaways
- Refinancing risk refers to the possibility that a borrower will not be able to replace an existing debt with new debt at a critical point in the future.
- Any company or individual can experience refinancing risk, either because their own credit quality has deteriorated or as a result of market conditions.
- One way to mitigate refinancing risk is to plan ahead for a scenario in which new credit is difficult to obtain at an attractive interest rate or impossible to obtain at all.
Understanding Refinancing Risk
Refinancing—replacing existing debt with new debt—is a common practice for both businesses and individuals. The old debt may be coming due, or the borrower may want to refinance it in order to attain a lower interest rate. In either instance, the borrower runs the risk that they won't be able to find an affordable new loan when they need it.
Any company or individual can experience refinancing risk—either because of external conditions (as in rising interest rates, tightening credit markets, or falling home values) or because their own credit quality has deteriorated.
An inventory-based business, for example, can lose an entire year of operations if financing is unavailable at the terms that it needs to make a profit. Most businesses seek to limit their refinancing risk by working closely with their lenders and investors to make sure that both understand the needs of the business.
It is risky to assume that you will be able to pay off an existing debt with lower-interest debt in the future because such a loan might not be available when you need it.
Examples of Refinancing Risk
There are numerous ways in which a business or individual that is depending on refinancing to cover their debt could end up losing money instead, Here are three such scenarios.
Refinancing Risk in Short-Term Debt
Consider a home-building company that takes on large amounts of short-term debt to fund its projects. The company's strategy is to regularly replace this debt with new debt. This works well for a number of years until credit markets suddenly seize up because of a financial crisis and banks become unwilling to offer the company any new loans. The builder may need to sell some of its properties at a large discount in order to quickly raise money to cover its obligations, resulting in a sizable loss.
Refinancing Risk in Home Mortgages
Imagine a homeowner with an adjustable-rate mortgage (ARM) who plans to refinance out of it at somefuture date—such as before an interest-rate reset—to avoid an unaffordable increase in their monthly payments. If interest rates rise or home prices fall in the meantime, they may be out of luck. This is essentially what happened in the subprime meltdown in 2007–2008.
Refinancing Risk in Longer-Term Debt
Suppose an electronics company makes a large offering of five-year bonds. The bonds are structured to provide small payments in the first four years, followed by large balloon payments in the last year. The company assumes that it will be able to cover these balloon payments with new bond issues. Just as the balloon payments are coming due, however, the company experiences a failed product launch that damages its profitability and financial condition. The company is unable to find financing to cover the balloon payments and must instead issue new equity at a discount to market prices. The company's stock price sinks as existing shareholders' holdings are diluted by the issuance of new shares.
Mitigating Refinancing Risk
Most financial transactions involve some degree of risk. That's true in investing and it's true in borrowing. Typically, whether we're professional investors, businesses with loans or lines of credit, consumers with credit card debt, or homeowners with a mortgage, we incur a particular debt because its risk-reward profile is attractive and within our tolerance for risk.
The best way to take some of the risk out of refinancing is not to count on conditions being favorable when you need to pay off a loan or want to switch, for example, from an ARM to a fixed-rate mortgage. That is also a powerful argument for not taking on too much debt in the first place. If paying your current debt is difficult, it may be next-to-impossible if you find yourself having to refinance it at a higher interest rate.
When Is It a Good Idea to Refinance a Home Mortgage?
Refinancing a mortgage can make sense if you'll get a substantially lower interest rate and/or reduce the term of your mortgage (from 30 years to 15 years, for example) so that you can pay it off sooner. However, even if interest rates are lower, you'll want to factor in closing costs and other upfront fees, as well as any possible prepayment penalties, which could negate much of the benefit.
What Are Prepayment Penalties?
Prepayment penalties are provisions in some loan contracts that require the borrower to pay a penalty if they wish to end the loan early, such as in the first five years of a 30-year loan. Before refinancing an old loan it's worth finding out whether it has such a penalty and, if so, when it expires.
What Is Cash-Out Refinancing?
Cash-out refinancing is a way that homeowners can access some of the equity that has built up in their home without having to sell it. In a cash-out refinance, the borrower takes out a new mortgage that is large enough for them to pay off their existing mortgage plus provide them with additional cash. The downside of cash-out refinancing is that the borrower is taking on more debt.
The Bottom Line
Many borrowers with loans and other debts face refinancing risk, often due to factors that are unpredictable and beyond their control. However, they can mitigate the risk somewhat by looking ahead and planning for the possibility that they may not be able to obtain new financing when they need to, especially at favorable interest rates.
