When it pays to refinance debt

CarolinaFireJournal - Loren Pittman
Loren Pittman
01/11/2012 -

The decision to take out a new loan is usually a pretty simple process driven by the need for a new truck, equipment, a station renovation or development, or a real estate purchase. The loan process is pretty straightforward, too. You select the best rate, terms and payments to fit your budget. The decision to refinance current debt, however, is often more complicated. The reasons and benefits may be unclear, and you may not fully understand how to go about it. The tendency is to stick with what you know. Instead, take some time to consider refinancing. It may be the perfect solution for your department.


Reasons for Refinancing

Although your department may have more specific reasons to refinance debt, some general reasons and potential benefits are:

  • Shorter terms, lower rates or both.
  • Lower payment obligations could allow you to prepare for a future project.
  • Reset to a lower payment amount after a large principal payment was made to provide future cash flow.
  • Get “cash out” to purchase equipment or pay off other obligations with higher rates, such as unsecured loans.
  • Move into a loan type that is more suitable for the department, such as replacing a variable or adjustable rate with a fixed rate, or converting a balloon loan into a traditional installment loan.
  • Managing funds responsibly may result in saving money that will free up funds for more up-to-date equipment and better resources. This, in turn, can impact the district’s ISO rating, provide lower insurance rates for the public and better fire protection for the community.

Old Rules of Thumb

There are some traditional rules of thumb that have been used to determine whether or not refinancing debt is in your best interest. The rules advise you to refinance if:

  • The new rate is at least two percent less than your current rate.
  • You will stay in the new loan for more than five years.
  • You will make up the costs to refinance within a 31-month period.

While these are good rules to consider, they are too general. You need to do a little more work to determine if refinancing is in your particular department’s best interest.

Deciding Whether or Not to Refinance

A good perspective to take when evaluating current debt is to think about what makes sense for the department now, as well as in the future. It’s also important to recognize that things don’t have to be done as they were in the past. Think of your department’s current loans and ask yourself, “If I had to borrow this amount today, would I take out a loan for the same rate, use the same collateral, and have the same terms and payments?”

You need not use the same financial institution as in the past either. Request proposals from at least three lenders, and make your decision based on the best pricing and the lowest costs and fees. Also, have some consideration for the level of service you are provided, the ease of the loan process, and the amount of time and energy you will spend providing financial information to the lender (now and for the duration of the loan).

As the borrower, you have the power to approach your loan officer with a plan you think will work best for your department. A good loan officer should work with you to help structure those plans into something beneficial for both the department and the financial institution. More than likely, your decision to refinance was spurred by the desire to lower your current rate and save money for your department. If you are considering refinancing to save money or any other reason, you want to be as cost-effective as possible. There are quite a few calculators and equations you can use to determine if refinancing is financially feasible, but one of the best methods is to compare the total payments for the duration of each term of the current debts to the payments of the proposed new debt on an annual basis. Factor in all costs associated with taking on new debt, as well as paying off old debt. Then, consider the time you plan on keeping the debt to full term versus paying it off early.

An Exercise in Refinancing

Here is an effective way to determine if it’s worthwhile to refinance. This exercise will only be accurate if the principal on your loans has not been paid down ahead of your regularly scheduled payments. First, you will want to list all of the debts you want to refinance. You will need two basic pieces of information about your current debts: annual payment obligations and maturity dates. Now follow these steps:

  1. Calculate your annual payments.
    If you are currently making payments on an annual basis, this will simply be your payment amount. If you are making monthly payments, you need to multiply your monthly payment by 12 to come up with your annual payment.
  2. Determine loan maturity dates.
    If you are unsure of your maturity date, you should be able to locate this on the promissory note or by calling your financial institution.
  3. Get a giant snapshot of your debt.
    Write down each annual payment beside the corresponding year the payment is due. The end result is that you will be able to see the actual annual payments you are responsible for making on all your individual loans until they mature.
  4. Determine your payments on the new loan.
    Make these calculations on your own, or contact your loan officer. When figuring a new loan amount, make sure it includes accrued interest and any prepayment penalties from existing loans. Also, consider any new loan fees, if they apply, and other costs involved with taking out a new loan. Now break out your annual payments for the new loan using the same methodology as you did with your existing debt, categorizing the payments by year until the loan matures.
  5. Compare your existing payments to the new payments.
    Compare the total annual payments of your existing debt to your total annual payments of your new debt by subtracting the new payment from your existing payments for each individual year. You will be able to tell from year to year how much the refinance either costs or saves you. You can also total the amount of payments over all the years for your existing loans and compare this with the total new loan payments to get an overall savings amount.

An illustration of the exercise just described will help you visualize how this looks in a chart format. In this example, we compare two existing loans to one loan we refinanced to a lower rate. The two existing loans have just had their annual payments made, so there is not much accrued interest to add to the new loan. Also, in this example we have added $3,000 in real estate transaction costs to help illustrate the breakeven point of how many years it takes for the interest savings to make up the costs associated with a real estate transaction.

As the chart illustrates, you can determine exactly how much you can save each year by comparing payments. In this example, the annual savings are expressed on a cumulative basis. The savings is greater in 2013 compared with 2012 because we have considered the $3,000 in closing costs as an immediate expense. Also, the savings become diminished over the final four years based on the total payments of the existing loan being reduced once Loan #2 is paid off in 2017. The overall savings of $50,453 greatly outweighs the closing costs involved; however, this will not always be the case, so it is always a good idea to run the numbers.

Pitfalls and Other Things to Consider

Collateral matters. When considering what collateral to use for refinancing debt, real estate may be an obvious choice. However, be aware there are usually additional costs associated with transactions involving real estate as collateral. For example, a commercial appraisal can range from $2,000-$3,000, while attorney costs can be an additional $500-$1,000. Using apparatus as collateral may come with little to no cost, but tying up something that may need to be replaced in a few years would also be ill-advised. When paying off your current loan, you also want to make sure you have taken into account any prepayment penalties. Check the promissory note on your existing loan to see if any exist. If they do, figure that as an additional cost to refinance.

One thing is for certain: loan rates are at historical lows. Now is the time to consider locking in a low rate for a long term, as long as it fits your situation. If you need assistance determining whether this makes sense for your department, contact your commercial loan officer.

Loren Pittman is a Commercial Loan Offi cer with LGFCU Financial Partners, LLC, a wholly-owned subsidiary of Local Government Federal Credit Union, working to improve North Carolina communities by partnering with, and making loans directly to, local government units across the state.
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