How to Refinance Your Investment Properties
About the author: Adam Luehrs is a writer during the day and a voracious reader at night. He focuses mostly on finance writing and has a passion for real estate, credit card deals, and investing.
The financing chapter of your investment story isn’t necessarily over just because you’ve closed on a mortgage. There may come a time when it’s advantageous to consider refinancing your investment property. You may be especially interested in refinancing a property because you’ve seen interest rates fall since you closed.
Unfortunately, that means that you’re currently stuck with a rate that’s eating away at your rental income every month. There are actually three goals on the table when approaching a refinancing opportunity.
● Lower your interest rate
● Alter mortgage terms
● Cash out your equity
There are some important things to know when you refinance real estate that’s being used as a rental. Will it really save you money in the long run? Are you actually in a place to apply for refinancing? Let’s break down the blueprint behind how, why, and when to do an investment property refinance plan.
What are some of the advantages of refinancing an investment property?
Refinancing is something that’s done strategically to reduce the overhead costs of owning an investment property. Ideally, a refinance will maximize the return on your investment. This happens through lower monthly mortgage payments. You’ll increase your rental income each month by decreasing your mortgage burden. Combining this strategy with savvy tax deductions can greatly increase the profitability of your investment property. That seems simple enough. Of course, the process of refinancing involves many moving parts that all require special attention.
The other reason to refinance an investment property is that you want to use the equity you’ve built up in an existing property to purchase new properties. Yes, it’s possible to use the equity from one property to fund future investment properties through a refinance situation. This option may pique your interest if you don’t have the capital on hand right now to invest in a new property.
Lastly, some people see a refinance as an attractive way to pay off a hard money loan. This approach gives you the best of both worlds in some ways because you’re able to get the quick cash infusion of a hard money loan combined with the traditional terms of mortgage loans. This can work for a property investor who is interested in getting financing quickly to jump on low-priced investment properties that require serious offers in a short amount of time.
The big detail to remember if you want to do an investment property refinance
Yes, you’ll need equity in your rental property before you can refinance. The standard required equity for a residential refinance is 20%. However, lenders typically push that to 25 to 30% for rental properties. You’ll typically need more equity if you’re attempting to refinance a property with up to four units. A really high credit score could give you some leeway. It’s still a good idea to try to get to that 30% sweet spot before you pour time and money into applications for refinancing.
Are there limits on what I can do with the money I get from a refinance?
Yes, most people who are focusing on refinancing for any reason other than lowering monthly payments simply want to fund more property purchases. However, you technically aren’t required to use your money for that purpose. The extra money you walk away with after refinancing is yours to use for whatever purpose you choose. Yes, that means you can fund your retirement, grow a college fund, invest in a company, buy stocks, pay off medical debt, and more! You can even simply take a vacation or buy a boat! The money really is all yours to spend however you wish!
There’s also the possibility of reinvesting the money in the same rental property to try to increase value. Adding value to your property through repairs or upgrades could pay off handsomely in the future. Some of the ways you can reinvest money after refinancing include adding an addition to increase square footage, replacing a roof, upgrading appliances, repainting the interior and exterior, finishing a basement, or adding a separate apartment.
How does changing the terms of a mortgage help you when you refinance your property?
This is an overlooked option that could help you to better align your mortgage with your goals as a property investor. For instance, it’s possible to change the terms of a loan to make it possible to own your rental property on a free-and-clear basis much sooner. You may also be interested in extending your loan term if your monthly income is barely enabling you to make a profit. It’s also possible to convert from an adjustable-rate mortgage (ARM) to a fixed rate in some cases. This can be advantageous if you’re struggling to make long-term plans in the face of rates that can fluctuate from month to month.
Is it hard to refinance a rental property?
Expectation is everything when going into an investment property refinance. You may already know that interest rates on investment properties are higher than rates for residential properties. That means you can’t base your expectations for a rate offer on what you see floating around for residential mortgages at the moment. In addition, lenders are much stricter when it comes to loan-to-value (LTV) ratios for rental properties.
A lender determines your LTV by dividing the mortgage total by the appraised value of your property. A higher LTV ratio means that you’re simply a higher risk to lenders. As a result, a high LTV could cut you out from ultra-low interest rates that would noticeably improve your rental income. Lenders like to see a maximum LTV ratio of 75% if you’re aiming to cash out with your refinance. You’ll be having an appraisal conducted as part of the refinancing process if you do decide to move forward.
However, you can still get a good picture of what your property will be appraised for even before you pay to have it formally appraised. Looking at the appraisal sums for comparable properties that recently sold in your neighborhood can give you an accurate picture of what to expect. What’s the bottom line? Crunch the numbers, shop around for lenders, and keep your expectations reasonable.
What do you have to show lenders when you refinance real estate?
Lenders look at a few different factors to get an accurate picture of your risk level as a borrower. The process isn’t dissimilar to the traditional mortgage process. Here’s a look at the indicators lenders use to evaluate rental property refinance applications:
● Your credit score (that usually means a score of 660 or higher to be approved for a conventional refinance and you’ll need to have a score over 760 to get plum rates
● Your debt-to-income ratio
● Your tax returns, asset statements, debt statements, and other financial statements
A traditional lender is also going to need to see a solid paper trail documenting your risk. Some lenders will ask for what feels like your entire financial history. Others may be more relaxed. You should still be prepared and willing to show your full deck if you’re going to submit an application to refinance. Here’s a look at some of the documents you may be asked to produce during the refinancing process:
● Pay stubs
● W2 forms
● Personal tax returns from the past two years
● Business tax returns from the past two years
● Proof of any disability income
● Proof of any pension income
● Recent bank statements
● Recent financial statements from brokerage accounts
● Recent statements from retirement accounts
● Proof of life-insurance policies
In addition, some lenders require rental property owners to provide proof that they have at least six months of rental income in the bank. Some lenders may also want to see proof of payment from your tenant in the form of bank statements or checks. Yes, this is a process that requires lots of paperwork and verification. Of course, the specific documents you’ll be required to produce will vary by lending institution. There’s no way to know what you’ll be asked to produce until you sit down to begin the query process with a lender.
There’s one more little mountain to climb as you explore the option of refinancing. Most lenders traditionally require property owners to have updated appraisals done before an updated mortgage can be finalized. Unfortunately, this could set you back a little bit because appraisals done for rental properties are significantly more expensive than appraisals done for primary residences.
What makes a lender likely to approve a refinance application?
Lenders have a little bit of tunnel vision when it comes to what they need to see on refinance applications. Yes, things like assets, income and debt are standard. However, it gets far more complicated than that.
Your debt-to-income (DTI) ratio may play a role in your ability to qualify for some lenders. They will like to see strong cash flow from a rental property before they’ll hit that approval button. You’re aiming for a DTI that’s no higher than 45% to be an attractive refinancing candidate. How can you know if that’s you? Take a look at your gross monthly income. Do all of your monthly debt obligations rest below 45% of what you’re taking in? You may need to pause on refinancing plans if you’re not there yet.
You likely need a minimum credit score of 660 score to be considered for a rental refinance. However, that’s just the minimum for a one-unit rental. Expect lenders to want a much higher credit score if you’re refinancing a rental property with multiple units. In fact, 720 might be the new minimum required of you if your property has three or four units. It’s important to ask a lender about score requirements early on in the process if you’re on the cusp.
A building has to be habitable if you’re planning to refinance. That means you may need to get a home in shape before this option becomes available to you if you’re in the process of turning a house that was intended to be a flip into a rental. Banks typically won’t allow you to do a standard refinance if you have more than 10 financed properties under your name. That means you may not be able to refinance a property until you’ve paid off at least a few of your loans if you own many properties.
Closing costs when refinancing a property
You’ll be required to pay closing costs whenever you refinance a home. This can feel a little bit like starting from "square one" again if you’ve already closed on a property once. Yes, this is one of the less pleasant aspects of refinancing a property. You may already have a good idea of what you’ll be paying for if you’ve closed on several properties while building your real estate portfolio. Here’s the rundown again:
● Appraisal fees
● Loan origination fees
● Title insurance fees
● Lawyer fees
You may have heard about no-fee refinance closings. Yes, this is an intriguing offer that banks and mortgage companies sometimes toss around. However, it’s good to take the approach that there’s no such thing as a free lunch when examining what’s being offered. Some lenders do wipe closing costs from the table when customers refinance loans.
Unfortunately, you’re not really escaping the costs. You’re simply escaping the "label" of closing costs. Banks that offer "free" closings simply bake those costs into other areas of a loan. You’ll typically see your loan amount or interest rate raised slightly to cover closing costs. Most borrowers simply feel more comfortable paying closing costs in a transparent way instead of feeling like they’re covering built-in costs.
Is it a good time to refinance a rental property?
It really takes putting all of the moving pieces that go into refinancing a rental property together to see if you’re in a good spot to refinance your property. Using a self-audit process before you spend time and money applying at banks and mortgage companies is the best strategy. Here are the big questions to ask before moving forward:
● Do I have at least 25 percent equity in the real estate investment property I want to refinance?
● Do I have a strong credit score of at least 660?
● Will closing costs eat away significantly at the cost benefit of refinancing?
● Is my DTI lower than 45 percent?
● Is my LTV below 74 percent?
● Is my property registered under my name instead of an LLC or company?
● Is the property I want to refinance in habitable condition?
This checklist represents some requirements you’ll need to meet to realistically qualify to refinance your property. You absolutely should shop around for lenders before making your decision. Additionally most applications you submit will result in a hard pull that impacts your credit score. Just keep that in mind if you’ll be applying for any additional financing for a new property relatively soon. A hard inquiry can impact your credit score for up to a year. However, it will stay on your credit report for a full two years.
The bottom line on refinancing an investment property
When done correctly, a rental refinance can help you make your property do more for you. Having equity in an investment property is a way to build personal wealth and leverage your assets for portfolio growth. It’s just important to understand the requirements to refinance real estate to avoid wasting time or money and this guide is a good start to give you insight to what more traditional lenders expect. Overall, a person with a good credit score and profitable property generally shouldn’t have any trouble getting approved for a new loan.
Please keep in mind that each lender has a different set of requirements and different processes to follow in order to move the refinancing process along.