Buying a rental property or investment property is one of many ways to generate regular income and build long-term wealth. However, if you have a high interest rate on your mortgage, you might be limiting your profit potential. Refinancing can lower your mortgage rates, freeing up some cash that you can use to cover other financial obligations, such as renovation.
While refinancing a rental property is similar to refinancing a primary residence, it works a bit differently. Here are some things you need to consider before you refinance your investment property.
What to Expect When Refinancing Your Investment Property
Some tips before you start your mortgage refinancing process:
- Gather relevant documentation
- Know your property’s value
- Rental properties have strict loan-to-value (LTV) requirements
- Interest rates on an investment property are typically higher than that of a primary residence
- You may have to pay closing costs
Reasons to Refinance Your Investment Property
Here’s why you may want to refinance your investment property loan and how it might benefit your current financial situation.
You Could Lower the Interest Rate on Your Mortgage
The most obvious reason people refinance investment property is to lower their interest rate. If you qualify for a higher rate than what’s currently offered in the market, consider refinancing your mortgage. A lower interest rate could mean lower monthly payments and more cash flow.
The interest rate you’ll get will depend on the housing market, your income, your credit score, and other requirements set by your lender.
You Can Change Your Loan’s Terms
Depending on your situation, you can shorten or lengthen your investment property’s repayment term. Although a shorter loan term will require high monthly payments, you’ll pay less interest down the road. The bottom line is that a shorter loan term can help you own your property outright sooner.
You can also extend your loan term to lower your monthly payments. However, with a longer loan term, you may end up paying more interest rates.
You Can Get Cash out for Renovations
As you pay off your mortgage loan, your home increases in value, and so does your equity. You can borrow against your home’s equity and use the cash-out refinance to finance renovations, pay a down payment on another real estate investment property or other expenses.
What Lenders Look For in an Investment Property Refinance
Lenders often put in place strict requirements for refinancing rental properties due to the high risk of borrowers defaulting. Generally, here’s what lenders look at when refinancing investment properties:
A Stable Debt-to-income Ratio
The No. 1 way lenders measure your ability to repay the loan you plan to borrow is by looking at your debt-to-income (DTI) ratio. An investment property owner with a low DTI ratio is considered a low-risk borrower who can manage monthly debt payments effectively.
Lenders are usually more willing to lend to borrowers with a low and stable DTI ratio than those with a high DTI ratio.
A Good Credit Score
Your credit score is an essential number in your financial life. Lenders look at your credit report to determine your risk as a borrower, so you need a good credit score. Lenders will not only be willing to refinance your investment property when you have a good credit history but also offer you lower interest rates.
Strict Loan-to-value Ratio Requirements
The LTV ratio measures the relationship between the loan amount you plan to borrow and the appraised value of the property you’re looking to purchase. A high LTV ratio typically presents more risk to the lender. As a result, loans with high LTVs have higher interest rates.
Higher Equity Thresholds
You automatically add to your home’s equity when you make a down payment. The higher the down payment, the higher the equity in your home. Lenders typically prefer borrowers who can make a sizable down payment because it reduces risk on their end.
Making more significant down payments comes with benefits, including securing lower rates, which can lower your monthly payments.
Rental Income Calculations
The amount of rental income you earn matters when it comes to refinancing. You can’t refinance all rental income, though. Apart from rental earnings, you may have to show other proceeds to prove that you can cover your monthly mortgage payments even when your property isn’t rented out.
How to Refinance Investment Property Mortgages
If you’re looking to refinance a rental or investment property, here’s how you can do it:
Build Equity
First and foremost, you need to build your home’s equity. You can do this by making a sizable down payment on a house you plan to buy.
Other ways you can build equity in your home include:
- Making home improvements that can increase your property’s value
- Making bigger or additional mortgage loan payments
- Refinancing to a shorter loan term
- Waiting for your home’s value to increase
You will have to stay below a mortgage lender’s maximum LTV ratio. Investors may have to wait a while for equity to accumulate, especially for 30-year mortgages. A high down payment or a 15-year mortgage will help you build equity faster.
Requirements and Documentation
Your lender will be asking you to meet certain requirements and provide documentation to start your refinancing process. Here’s the paperwork you need to gather:
- Proof of Income: If you’re employed, you’ll need to show your lender your original pay stubs for the last 30 days. And if you’re self-employed, your mortgage lender may ask for your bank statement or any other documentation as proof of income.
- Homeowners Insurance: This shows the lender that your property has enough coverage.
- Tax returns and W-2 forms: Lenders may also ask for copies of your W-2 or 1099 form to prove your employment and income history.
- Asset Information: You may need to present every detail of the assets you own, including bank statements, investment accounts and retirement accounts.
- Title Insurance: Lenders use title insurance to verify that the investment property you want to refinance is yours.
- Rental Agreements: Also called lease agreements, it helps the lender determine the profitability of your investment property.
- Appraisal: Your lender may also order an appraisal to determine the market value of your home.
Check Your Debt-to-Income (DTI) Ratio
As mentioned earlier, lenders use the DTI ratio to determine borrowers’ ability to manage monthly debts. Therefore, before applying for mortgage refinancing, it’s prudent to check your DTI ratio. The lower your DTI ratio, the better chance you’ll have of getting a refinance mortgage for your investment property.
Real estate investors can improve their debt-to-income ratios by increasing their income, paying off debt, or refinancing debt to reduce monthly payments. While anyone can make extra money with a side hustle, real estate investors may have more opportunities to grow their income, such as career advancement or raising rent prices to keep up with inflation.
Paying off debt will also help, but real estate investors looking to scale often shy away from paying dues early. Extending your loan’s term while initiating a cash-out refinance can keep your DTI ratio within the mortgage lender’s requirements.
Get an Appraisal
A home appraisal is a crucial step in mortgage refinancing. It is the unbiased valuation of the property by a professional to determine the fair market value. Most banks, credit unions, and online lenders will require an appraisal as a part of the application process.
Ensure that you get your investment property appraised before refinancing. That way, you will know how much capital you can receive.
Save for Closing Costs
There’s a lot that goes into mortgage refinancing. You may want to pay closing costs, which can be a considerable expense. Saving for closing costs, like origination fees, appraisal fees, and title insurance, can speed up your mortgage refinancing process.
What are Your Options for Refinancing an Investment Property?
You can refinance a property to change its rate and terms. It’s also possible to tap into your home equity with a cash-out refinance. Understanding the advantages of both strategies can help you make better decisions as a real estate investor.
Changing your rate and terms can reduce your monthly mortgage payments, which will increase your cash flow. Turning a 5-year mortgage into a 10-year mortgage will keep you in debt longer. However, some investors value the additional cash flow and are okay with taking out longer loans as long as they are cash flow positive.
A cash-out refinance can also result in lower monthly payments if you extend your loan’s duration. However, the main advantage of this refinance is the extra capital you receive from your home equity. Some real estate investors use cash-out refinances to gather extra funds for a down payment on another property.
When real estate investors want to scale, they often use cash-out refinances, home equity loans, or HELOCs to raise money from their existing properties. Getting extra money this way makes it easier to buy more real estate.
While a home equity loan and a HELOC will increase your monthly expenses, you can keep your monthly expenses the same with a cash-out refinance. If you have a 5-year mortgage and convert it to a 20-year mortgage, you might end up with a similar monthly payment. Your mileage will vary based on your current loan’s length and the length of the new loan’s term.
Why Should You Cash Out Refinance an Investment Property
A cash-out refinance is a great choice for many investors, but it’s not for everyone. Understanding the advantages and pitfalls will help you determine if it makes sense for you.
How a Cash Out Refinance Works for an Investment Property
Refinance loans change your loan terms and rates. You are getting a new loan that will pay off your current mortgage. Many mortgage lenders offer these products but have various requirements, such as a minimum credit score and a debt-to-income ratio.
If you qualify for a cash-out refi, you will first have to decide how much cash you want to take out. That amount will determine your new loan’s balance. For example, if you have a $500,000 mortgage and want to take out $200,000, your new mortgage balance will be $700,000.
You can even end up with a different type of loan. Some investors refinance FHA loans into conventional loans to avoid paying mortgage insurance premiums after building up 20% in home equity. Some investors switch out of adjustable-rate mortgages so their monthly payments are more predictable.
However, you cannot exceed a designated loan-to-value ratio – usually 80% – when you initiate a cash-out refinance. In the previous example of turning a $500,000 balance into a $700,000 balance, you cannot go through with that cash-out refinance if your property value is $800,000. A $700,000 balance on an $800,000 property would result in an 87.5 LTV ratio, which most lenders will reject.
If the property is worth $1 million, cash-out refinancing will work since a $700,000 balance only leaves you with a 70% LTV ratio. You can use these Freddie Mac and Fannie Mae loans to cover various purchases, such as the down payment for a second home. You can use a cash-out refinance for a primary home.
The Pros and Cons of a Cash Out Refinance
A cash-out refinance can be a good option, depending on how much equity you have in your home. These are some of the pros and cons to keep in mind.
Pros:
- Possibly get a lower interest rate
- Reduce your monthly payments in some scenarios
- Tap into your home’s equity and receive a lump-sum payment
- Get out of a bad mortgage loan
- Get the necessary funds to take on a second mortgage
- Receive extra money that can help with personal expenses and other financial needs
- Use the extra money to make home repairs that increase your property’s value
Cons:
- You will change your loan’s terms and rates, which isn’t good if you like your current loan. A home equity line of credit may be a better choice in this scenario.
- You stay in debt longer
- You pay more interest in the long run
- Closing costs can get expensive
- A hard credit check will temporarily reduce your credit score
Conclusion: Assessing If Cash Out Refinance Is Right for Your Investment Property
A cash-out refinance can be a great move if you want to buy a secondary home or another investment property. You will increase your cash flow and end up with more tax deductions. Interest payments from a mortgage are deductible up to the first $750,000 of mortgage debt for your primary or secondary home (this amount drops in half for single tax filers). It’s important to weigh the pros and cons while considering alternatives like a home equity loan or a HELOC. Cash-out refinances are often the best choice for preserving cash flow while getting the capital that you need.
