Refinancing fees: profit center or client protection mechanism?

The FINANCIAL — You have a loan, but you want to move that loan to another lender: maybe another organization offers to reduce your monthly payments, or to extend the maturity.

This process is called refinancing. Often banks and microfinance organizations will charge their customers a refinancing fee when they take their loan somewhere else.

Financial organizations, whether it be banks or microfinance organizations, have a myriad of different policies on whether to charge refinancing fees, and how much to charge. Some organizations do not charge them at all, while others charge steep fees. Usually they are expressed as a percentage of the outstanding balance or the original principal. In this article, I’ll discuss how this impacts you as a client, and why companies charge these fees.

Make sure that you understand the clauses on refinancing fees in your credit contract before you sign it. High refinancing fees are not necessarily a reason not to sign the contract. For a lot of people they can actually be a good self-control mechanism that forces them to pay off them loan and not remain in debt. However, if you do decide to consider refinancing your loan, refinancing fees will change the way you make your decision. If you take out a loan, and a few months later, another company lowers interest rates, or promises to refinance your loan with a longer maturity, the refinancing fees might cancel out the savings that you get from refinancing your loans. Look for example at table 1, where although organization B’s interest rate is lower, it does not make financial sense for the borrower to refinance his loan from organization A with organization B.

Table 1: Refinancing can make sense, if the new loan is significantly cheaper. However, you should always take into account that your old lender will probably charge you a refinancing fee. In this example, we look at an unamortized, $1000 house loan with one year remaining. The interest rate on the old loan is 3% while the interest rate on the new loan is 2.7%. The refinancing fee is 10% of the principal of the loan.

So why would a company charge refinancing fees? There are a number of possible reasons. First, as discussed above, it prevents clients from leaving the company as soon as they see a better offer elsewhere. They will no longer move their loan for a small difference in interest rates, because the refinance fee can be prohibitively costly.

Second, it helps the company’s bottom line, or in other words, its profits. People who want to refinance their loans are people who are going to leave the company, so an organization might as well extract some extra profit out of them.

Third, and perhaps most importantly, some organizations see a problem with over indebtedness. Clients jump from organization to organization, refinancing their loans, racking up more debt in the process, without actually every reducing their debt. This process usually continues until nobody wants to refinance that person’s loan anymore, and their collateral (usually their house) has to be sold, and the family loses everything. A refinancing fee can possibly stop this process, and force a client to actually pay off some of their debt, which will improve the family’s financial health.

Does a refinancing fee restrict clients’ freedom? In a way it does: a client, by signing a credit contract with the refinancing fee in it, voluntarily ties herself to the organization, by making it harder to move her loan. However, experience has taught us that many clients do not read the contracts they sign, and often do not understand them, even if they do take the time to read them.

As a financial institution, you are constantly trying to find a balance between making profit, and protecting your client, not just against the evil outside world, but against himself. In this case, the balance is even harder to find, because making a profit and protecting your client can go hand in hand, but are perceived as being very different.