Most small- to medium-sized enterprises (SMEs) are very cautious about not only applying for funding but also applying for additional funding. This is usually because most are averse to the complex paperwork, are not fully compliant with the funding they need, and some are fearful of not being able to repay the loan.
Although it’s good for SMEs to avoid unnecessary funding because it can get expensive, there is a way to be strategic in applying for additional capital. Most people call this refinancing. According to reports, only 3% of SMEs in South Africa have used home loan refinancing to fund or support their business, while formal business loans are utilised by just 7%.
There are other factors that influence the above data, but SME founders need to know how to practice refinancing without putting their business in jeopardy. In this article, we look at what refinancing is, how it works and the best strategies for SMEs looking to refinance.
What is Refinancing?
Business loan refinancing involves replacing one or more existing loans with a new finance arrangement. The new facility pays off the original borrowing, and the business repays the new loan under new terms.
Refinancing can involve:
- Securing a lower interest rate
- Extending or shortening the repayment term
- Consolidating multiple debts into a single facility
- Restructuring short-term borrowing into a longer-term solution
- Accessing additional capital alongside the refinance
Refinancing vs Debt Consolidation
Although often used interchangeably, refinancing and debt consolidation are not the same thing. Refinancing means replacing an existing loan with a new one. A business only needs one outstanding loan facility to refinance.
In comparison, debt consolidation means combining multiple loans or finance facilities into one larger one. The new lender pays off the existing debts, leaving the business with one repayment, one lender and one set of terms to manage.
Some refinancing arrangements can include debt consolidation as part of the process, especially where a business has accumulated various loan facilities over time
Types of Refinancing
Refinancing may broadly fall under these types, each with a different purpose:
- Rate and term refinance: This replaces an old loan with a new loan that has better terms, like a lower interest rate. The goal is typically to save money.
- Cash-out refinance: This is when a new loan that’s higher than the current loan is taken out to tap into equity. This new loan is used to pay off the old one and keep the difference.
- Cash-in refinance: Typically a good option if there is a lump sum of cash the loanee wants to use toward debt. The new loan is smaller with new terms and is used to help business owners qualify for lower rates and get out of debt sooner.
Pros and Cons of Refinancing
Here are some of the pros and cons of refinancing you need to consider before deciding if it’s a good choice for you and your business.
Pros
- Save money on interest: The most common reason to refinance debt is to achieve a lower interest rate. Homeowners often refinance their home loans when rates go down to save money.
- Lower monthly repayments: Refinancing can help you lower your monthly payments if you extend the term of your loan.
- Can be used to consolidate more pricey debt: If you use a cash-out refinance to pay off credit card or personal loan debt, you may be able to save money and simplify your payments.
Cons
- Increase overall cost of debt: If you do a cash-out refinance, or rate-and-term refinance, you could end up staying in debt for more time. That may mean paying more in interest overall, though it depends on the specifics of your new loan. Also, refinancing can mean paying closing costs, which is an added expense.
- Monthly payments could increase: Depending on the terms of the loan you take out, your monthly payments could also go up; for example, if you refinance a loan when rates are higher, take out a loan with a shorter term or cash out some of your equity.
- Negative impact on your credit: Refinancing means applying for a new loan, which leads to a hard inquiry on your credit report. Hard enquiries have a small, temporary negative impact on your score. A refinance can also reduce the average age of your credit accounts, because you’re replacing an older debt with a newer one.
How Refinancing Works
While specific requirements can vary between lenders, the refinancing process typically goes as follows:
1. Review Your Current Borrowing
You need to start by understanding your existing position; consider things like:
- Outstanding balances
- Interest rates
- Monthly repayments
- Remaining loan term
- Early repayment charges or penalties
A refinancing decision must always be based on the total cost of borrowing, not the headline monthly repayment.
2. Define Your Objectives
Before approaching lenders, you need to identify what you are trying to achieve. For example:
- Lower monthly repayments?
- Better cash flow?
- Debt consolidation?
- Additional funding for growth?
- Greater certainty through fixed repayments?
Clear objectives make it easier to assess different offers.
3. Explore Available Options
Businesses can refinance in many ways, including:
- High street banks (Standard Bank, Nedbank and Absa)
- Challenger banks (TymeBank, Capitec, Discovery Bank)
- Community development finance institutions
- Specialist business lenders
- Commercial finance brokers
Lenders will assess factors such as business performance, affordability, credit history and repayment record before presenting you with an offer.
4. Compare Total Costs
The cheapest option is not always the one with the lowest interest rate. Businesses should consider:
- Arrangement fees
- Legal fees
- Valuation fees
- Early settlement charges
- Future flexibility
A thorough comparison of total borrowing costs is critical before you accept an offer.
5. Complete the Refinance
Once approved, the new lender uses the funds to clear the existing debt. The business then begins making repayments under the new agreement.
SME owners should consider refinancing because it can lower borrowing costs, improve cash flow and enable a consolidation of other debts into one manageable payment. However, refinancing must be done if the business can afford the added loan facility.
