Chances are that if you are paying on a mortgage for a rental property, you have probably at least heard about refinancing it. Refinancing a rental property means that you are paying off one mortgage by opening another one. You are basically exchanging one mortgage for another one. This may seem counterproductive, but it does have potential benefits. In this guide, we will discuss why you might choose to refinance a rental property, tips on doing it successfully- and smoothly- and alternatives of refinancing.
Common Reasons People Refinance a Rental Property
While there may be several different reasons to refinance a rental property, some are more common than others:
Lower Interest Rate
Often, under the right conditions, you can get a mortgage lower interest rate when you refinance a rental property. Everyone can benefit from a lower interest rate.
Pay a Mortgage Off Quicker or Give Yourself Longer
When you refinance a rental property, you can either extend or shorten your repayment term. For instance, if you currently owe 20 more years on your mortgage, you could refinance with a lower interest rate to a 15-year mortgage. You might also refinance when you only have 10 years left to pay to another 15 or 30-year mortgage.
Lower Your Monthly Payments
If you refinance a rental property, you can lower your monthly payments. If your interest rate is lower, your monthly payments will be lower. Also, if you extend your repayment term, your monthly payments should be lower. This makes it easier to repay.
Use Equity for Other Needs, Desires, or Investments
Some people also refinance to take care of other things, such as:
- Paying off debts
- Taking care of college costs
- Purchasing a new investment property
- Paying off their primary home’s mortgage
- Paying for repairs to one or more properties
Tips to Refinance a Rental Property
Refinancing can seem overwhelming and complicated, especially if you are new to it. We wanted to give you some tips on how to make the process simple, quick, and successful.
Understanding Your “Why”
Why exactly do you want to refinance a rental property? Is it to lower your monthly payments? Is it so that you can get some work done on the property? Do you want to use your equity to purchase another rental property? By understanding your reasoning behind it, you can make better decisions, including how much you try to refinance it for and how long you choose to extend your mortgage. It may also help you decide what lender to refinance through as well as what program to use.
For instance, if you are just hoping to lower your payment, you can simply refinance the balance left on your current mortgage. If you are hoping to buy a new property or use the cash to work on the property, you will need to refinance for more than the balance. You do not want to end up owing more unless you have strategic plans for that money.
Check Your Equity
Equity is the amount of the home you actually own. It is the value of the property minus the balance you owe on your mortgage. In order to refinance a rental property, you need to have equity to work with, especially if you are attempting to refinance for more than your current balance.
Choose How You Want to Refinance a Rental Property
There is more than one way to refinance a rental property. There are two basic ways to refinance, and the way you choose to go will depend on your goals. They are as follows:
#1 Refinance for the Exact Amount of Your Mortgage
In this case, if you owe $30,000 on your mortgage, you would get a refinance loan for $30,000. This might be a little more or a little less depending on the closing costs and anything extra you need to pay. However, your new loan would be for around that $30,000 plus interest and so on. This type of refinancing is for those who are just looking to lower their interest rate or extend their payment term.
Something to remember here, though, is that if you only owe $30,000 at this moment, you will end up owing more overall. This is because that $30,000- money that already includes the interest from the original mortgage- will now have more interest added. It can still be beneficial, though, depending on the specifics of the loan. This is just something to factor into your decision.
#2 Cash-Out Refinance
A cash-out refinance is a refinance home loan in which you not only borrow enough to cover the balance of your mortgage, but also some of the equity you own in the home. Typically, the lender will let you borrow around 70 or 80 percent of your equity.
This type of refinancing gives you extra cash to use for other things, so it is the way borrowers go when they are looking to pay off debt or make other financial moves. The downside of the cash-out refinancing is that you are adding money onto what you owe. Again, this does not necessarily make it a bad move. It is just something to take into account when making your decision.
Know What You Need to Refinance a Rental Property
Before you go apply for a loan, know what you need. Typically, you will need items such as:
- ID and Social Security Card:
You have to prove you are who you say. Some lenders may require other forms of ID, but most will be fine with a driver’s license and social security card.
- Tax Returns:
They usually want to see one to three years of tax returns. Play it safe and take three with you when you apply. That way, you are covered.
- Mortgage Statements:
They will need to see what you owe and how much of the property you own to calculate a loan amount. Additionally, many mortgage loans and refinance loans require that you wait a certain period of time after your original loan is taken out before you get a new one. Take everything you have related to your current mortgage so you are prepared for anything the lender asks you for.
- Proof of Income:
Along with your regular income, taking proof of income from the rental property can help a lot. Obviously, if your only income is that from the rental, you will already be taking this. For most people, though, rental income is more of a side income or they have multiple properties that they rent out. Regardless, the more income you can show, the better chance you have of successfully refinancing.
- Property Deed:
The lender will need to see information related to the actual property, including any deed work or other paperwork showing that you are purchasing it.
There is a chance that the lender will require more, including proof of insurance, homeowners association membership, and more. Some require very specific breakdowns of the value of the property while others do not. Most will also require a new inspection to be done. When you have chosen a lender, be sure to find out everything they require from you so that you can minimize the amount of time it takes for approval.
Check Your Credit
When you are applying for any type of loan, your credit score is important except under very specific circumstances. Some lenders will take other things into account for some programs, but having a good credit score can improve our chances of success greatly. Good credit can also get you good interest rates and better repayment terms. And- let’s face it- if you are not getting a better interest rate, you are probably fighting against yourself. You want to experience benefits if you refinance a rental property. A higher interest rate will not help you reach that goal.
Before you begin applying, take a look at your credit. Call around to different lenders to find out the minimum credit score they will approve. Most lenders want to see over 600, but some will work with a 580. If your score does not make the cut or is at the lower end of that spectrum, take some time to work on improving it. Even a jump of 20 or 30 points can make a big difference in the interest rate you pay.
Just like shopping for an original mortgage, it is important that you shop around when you want to refinance. You want to be sure that you get the absolute best insurance rate you possibly can and the best terms. Never go with the first offer you come across. The first lender might have the best offer, but you should never just assume that. Do your research and check into at least a few lenders. By filling out this form below, you can get offers in a matter of seconds. Try it right now:
Lock-In Your Interest Rate
Usually, when you apply for a loan and get a preapproval, you can choose to lock in the interest rate. This means that for a certain period of time, often around 30 days, that interest rate is guaranteed. If you complete the loan after that time period, you are subject to the current interest rate, which can be higher than the one you were guaranteed.
Consider a Mortgage Broker
Many people find better success working with mortgage brokers than with a lender. Mortgage brokers are professionals who are associated with a group of lenders instead of lending money themselves. Their group of lenders tends to be a mixture that has different requirements and different products, so they can usually find a loan product that suits a borrower’s individual needs.
An individual lender usually has only one loan product- possibly a handful- but most have the same basic requirements. If you choose to refinance a rental property, talk to a mortgage broker. They may be able to find you a better loan product than your typical bank or other lenders could.
Understand the Downsides
You didn’t think it would be all good, did you? Unfortunately, everything has downsides. Sometimes they are worth it and sometimes they are not, but it is important that you know what they are so that you can decide. Here are some of the common downsides of refinancing a rental property:
Increase In Debt
If you are borrowing more than your current balance, you are increasing the length of time you will be paying the debt.
You will be paying closing costs all over again. When you first purchased the property, you paid closing costs. You might have gotten lucky and the seller paid the closing costs, but either way, closing costs have already been paid. Refinancing means paying closing costs again- and this time, there is no seller that might take care of it. If those closing costs are added to your loan, that means more interest and more you are paying out.
Do some calculations. Determine how much you will be saving by refinancing a mortgage for a lower interest rate. Then, determine how much you will be spending out in closing costs. Will you be saving a lot more than you will be paying in closing costs? If not, refinancing is probably not the way to go. This is especially true if your only purpose of refinancing a rental is to get a lower interest rate. If the closing costs will cancel out the money saved, don’t waste your time.
When you first took out a mortgage, your amortization schedule had most- if not all- of your mortgage payments going towards the interest. Over time, more of the payment began going to the principal. If you do decide to refinance, it is like starting that schedule all over again. You will start out paying more towards interest and eventually paying on the principal. It is almost like undoing all of the hard work you have already done.
Alternatives to Refinancing
If you have decided that refinancing is not the route you want to go, there are other ways to meet your goals:
Personal Loans, HELOC, and Other Financial Tools
Refinancing is not your only option if you are in need of extra cash. In fact, you have several other financial tools you should consider. Think instead of options like personal loans and HELOC (home equity line of credit). You can get a personal loan if your credit is decent. Even if it is not, you can get a secured loan by putting up some form of collateral- like the title to a vehicle, an investment account, or something similar.
A HELOC is getting a loan based on the equity you have in your home. Unlike refinancing, though, this is a completely separate loan. There is a chance that you can get a lower interest rate on a HELOC. Additionally, you only take out the money you need as you need it and only make monthly payments on what you have borrowed. This option can save you a lot of money over time- especially if you do not need the full amount of your equity.
Make Extra Payments
If your goal of mortgage refinancing was to lower the amount of interest you owe or shorten your repayment term, you can do both of those by making extra payments on your current mortgage instead. Did you know that making one extra payment a year can knock years off of your overall loan term? It is true. For some loans, you can knock three to five years off of your mortgage loan with just one extra payment. That is because you are paying more towards the principal, so less interest is charged overall.
The best part? It is not even as hard as it may sound to make that extra payment. All you have to do is change how you make your payments. Instead of making one monthly payment, make a payment every two weeks.
For instance, if your monthly mortgage payment is $600, pay $300 every two weeks. Why does this work? Just some simple math: If you pay once a month, you are making 12 payments per year. If you pay every two weeks, though, you are making 26 payments each year, which is the equivalent of 13 monthly payments. That puts an extra $600 a year going to your principal since you have already paid your interest. Doesn’t seem so bad, does it?
Additionally, if you can pay just an extra $5 with each of those payments, you are putting another $130 straight to the principal. If you just absolutely cannot squeeze any extra out of your income, you can make that extra cash through yard sales and other quick cash tasks.
If refinancing a rental property is the way you want to go, you want to take it one step at a time. Getting in over your head is not a desirable income, so you want to prepare as best as you can. Use this guide to help you along the way but do not be afraid to do more research if you are not yet comfortable with the idea.
Brandy Woodfolk is an educator, home business owner, project manager, and lifelong learner. After a less than stellar financial upbringing, Brandy dedicated her schooling and independent studies to financial literacy. She quickly became the go-to among family, friends, and acquaintances for everything finance. Her inner circle loves to joke that she is an expert at “budgeting to the penny”. Brandy dedicates a large portion of her time to teaching parents how to succeed financially without sacrificing time with their little ones. She also teaches classes to homeschooled teenagers about finances and other life skills they need to succeed as adults.
Brandy writes about smart money management and wealth building in simple and relatable ways so all who wish to can understand the world of finance.