Refinancing an investment property is sometimes the best option for saving money.
Rental income is a potential source of income, but your loan may prevent you from fully utilizing it. Refinancing a rental property can help solve financial issues such as a high-interest rate or a lack of liquid assets to invest in something else.
Refinancing a rental property is the same as refinancing a personal residence. There are, however, a few significant differences. Here’s everything you need to know about refinancing a rental property.
Financing a Rental Property
The specifics of refinancing a rental property will depend on your circumstances, but following these steps will prepare you and keep the process moving forward.
First, get your paperwork in order. Proof of income, W-2 forms, financial statements, and proof of homeowners insurance are some documents your lender requires. Any application processing delays could be caused by missing or outdated documentation.
The second step is to fill out and submit an application. Please send it in once you have finished your research and have everything you need to apply. This is very common in the digital world. Keep an eye out for additional instructions from your lender. Before submitting a formal application, check if any of the lenders you’re considering offer pre-approval or pre-qualification.
The third step is to obtain a fixed interest rate. After reviewing your application, a lender will (ideally) make you an offer. Examine the offer terms and compare them to other quotations you have obtained. Keep in mind the interest rate and fee structure. Upon accepting the offer, you must immediately lock in your rate. If you do nothing, the offered rate of interest may increase. This range is subject to change by the lending institution. You need this information to complete the refinancing process before the rate lock expires.
Fourth step: maintain composure while underwriting continues. Once the lender has approved your application, you will enter the underwriting phase. Verifying your income, assets, and the property’s condition will be necessary, so be prepared to provide supporting documentation. During the underwriting process, at least a week may pass.
Finalizing the loan is the fifth and final step. Before you can meet with your lender to complete the refinance and pay any closing costs, the underwriter must approve the transaction. As of June 2021, ICE Mortgage Technology determined that the average closing time for a refinance loan was 48 days.
Refinancing a Rental Property and Its Advantages
Refinancing a rental property is desirable for a variety of reasons.
You are reducing one’s interest rate. Saving much money over your loan’s term is possible with a low-interest rate. If you take out a 30-year mortgage for $150,000 and the interest rate is 5% instead of 6%, you’ll save almost $34,000. According to G. Brian Davis, real estate investor, landlord, and co-founder of SparkRental, which offers property management software for landlords, rental property refinancing tends to be more expensive due to the increased risk.
The housing market, credit history, income, and other factors will influence the interest rate you receive from your lender.
You are changing the time frame of the payments. If you want to be a homeowner sooner rather than later, you should reduce your repayment term. Interest costs can be reduced by decreasing the loan term, but this comes at the expense of higher monthly payments. If you need help making your payments on time, extending the length of your loan’s repayment term can help.
But, selling your shares of stock. You can use the funds from a cash-out refinance for anything you like, including the purchase of additional property, the settlement of existing debts, or the payment of necessary expenses. However, the potential drawbacks must be carefully considered.
Requirements for Refinancing a Rental Property
Before applying, here is what you should know about the requirements:
Loan-to-value ratio. When repaying a rental property, lenders require a more significant amount of equity than with a conventional mortgage. “In a financial crisis, lenders recognize that debtors are more likely to default on investment property loans than on their primary residence mortgage,” Davis explains. For example, Freddie Mac stipulates a maximum loan-to-value ratio of 75% for refinancing investment properties with two to four units, meaning you must have at least 25% equity. Comparatively, you can refinance a Freddie Mac-owned or -securitized one-unit primary residence up to 95% LTV.
Strong credit. Before submitting a refinancing application, you should confirm that your credit is in good standing. Leslie H. Tayne, the author of “Life & Debt” and debt resolution attorney and founder of the Tayne Law Group in New York, says, “If you don’t have good credit, it’s unlikely you’ll get a lower interest rate.” Tayne states that most lenders will approve refinancing a rental property with a credit score of at least 620. Still, a credit score in the good (at least 670) or excellent (at least 800) range can help you qualify for the best available interest rates.
Eligible income. It also matters how much money you earn and where it comes from. “Rental income may not be eligible for the refinance,” says Tayne. To increase your chances of approval, it helps to have six months’ worth of payments in the bank, so the lender knows you can continue making payments even if the property is vacant.
Debt-to-income ratio. Your debt-to-income balance will also play a role in refinancing your rental property. As with a conventional mortgage, lenders will want to ensure you do not have excessive debt. Your DTI will be determined by dividing your total monthly debt obligation by your gross monthly income.
Are There Any Drawbacks to Refinancing an Existing Rental Agreement?
There are a few reasons why refinancing is a poor business decision, although it could save you a significant amount of money and help you bring in more money from rentals.
To begin, the closing costs for a mortgage refinance are typically at least 2% of the loan amount, which can amount to several thousand dollars. Additionally, the interest rate on the new loan may increase.
When a lender rolls these costs into the loan principal, they do so for the borrower’s convenience; however, this makes it more difficult to understand how much the refinancing will cost. “Borrowers tend to disregard the fact that they just spent thousands of dollars simply because it didn’t come out of their checking account,” says Davis. “Borrowers tend to ignore that they just spent thousands of dollars.”
If you roll your closing costs into your loan, you will have to pay additional interest on them, but those costs will also cancel out any savings you would have received from a lower interest rate.
Resetting the amortization schedule is the second potential problem that could arise from refinancing. When you get a loan, the majority of the interest that you owe will be paid at the beginning of the process. “The further along the loan term you get, the more your payment starts going towards the principal,” says Davis.
However, resetting the schedule is part of the refinancing process, which means that most of your payments will once again go toward the interest. It is ultimately up to you to run the numbers and determine whether or not refinancing your rental property is the best course of action to take.
