How to Refinance a Rental Property
A rental property can offer income, but your loan could be limiting rental income profits. If you've been stuck with a high interest rate or don't have the cash on hand to jump on another investment, refinancing a rental property may be the key to opening up even more financial opportunity.
On the surface, refinancing a rental property isn't much different from refinancing your home. But some important distinctions apply. Before you get started refinancing your rental or investment property, here's what you should know.
When Should You Refinance a Rental Property?
There are a few reasons refinancing a rental property might make sense. Your interest rate is usually the primary concern. If you have a high interest rate and can refinance for a lower rate, it's worth considering, says Andrew Helling, a former Nebraska real estate agent and owner of REthority.com, an online resource for real estate professionals and their clients.
Say you took out a mortgage for $150,000 at a 6% annual percentage rate for 30 years. The monthly principal and interest payments would be $899, and you'd spend $173,757 in interest over the life of the loan.
Now say your interest rate was 5% instead. Monthly payments on that loan would be $805, and you'd pay $139,884? in total interest. That's a savings of $33,873, thanks to a difference of just one percentage point.
Other reasons you might refinance include shortening or lengthening the repayment term, or cashing out your equity to buy more property. However, it's important to weigh the potential downsides carefully.
[Read: Best Mortgage Refinance Lenders.]
Is It Hard to Refinance a Rental Property?
Refinancing a rental property calls for greater requirements than you'd expect from a traditional mortgage refinance. But that doesn't mean it's impossible.
What lenders look for when you refinance a rental property
Before you begin the application process, there are a few documents you should have ready. These include:
-- Proof of income. Usually, a recent pay stub from your employer will satisfy this requirement. However, if you're self-employed, you will need to show some other form of income validation, such as a bank statement.
-- W-2 forms. Your W-2s will help the lender verify your employment history and income. Only copies are needed, not originals. Again, self-employed individuals will likely need to supply additional tax documentation.
-- Proof of homeowners insurance. You'll need to provide a recent bill from your insurance company or some other form of proof that your home is adequately covered.
-- Proof of title insurance. Make sure you have a copy of your title insurance handy to help verify that you are, in fact, the owner of the property. This also provides the lender with additional legal and tax information related to the property.
-- Financial statements. Finally, you'll need to show all the assets you own, including bank, investment and retirement savings accounts.
Once you have all the necessary documentation in place, you can begin applying to refinance.
Rental property refinancing requirements
Keep in mind that when you refinance a rental property, the requirements are a bit different from a traditional refinance. Here's what you should know about the requirements before you apply:
-- Loan-to-value ratio. When refinancing a rental property, lenders ask you to have more equity built up than with a traditional mortgage. "Lenders know that borrowers are more likely to default on investment property loans than their home mortgage in the event of a financial crisis, so they're higher-risk loans," says G. Brian Davis, a real estate investor, landlord and co-founder at SparkRental, which offers property management software for landlords. In most cases, the lender will require a maximum loan-to-value ratio of 75% to refinance, which means you need at least 25% equity. By comparison, some lenders allow borrowers to refinance traditional mortgages up to 100% LTV.
-- Good credit. Before applying to refinance, you should verify that your credit is in good shape. "If you don't have good credit, you're not likely to get a lower interest rate," says Leslie H. Tayne, author of "Life & Debt," a debt resolution attorney and founder of the Tayne Law Group in New York. Most lenders will approve you for refinancing a rental property with a credit score of at least 620, but a credit score in the good (at least 670) or excellent (800 or more) range will get you the lowest rates available.
-- Higher interest rate. Even though the goal of refinancing is often to get a lower rate than your current mortgage, rental property refinancing tends to be more expensive -- both in interest rate and fees -- due to the increased risk, Davis says. For example, you can expect investment property refinance rates to be a minimum of 0.5 to 0.75 of a percentage point higher than conventional mortgage rates. The interest rate you ultimately get will depend on the housing market, your credit score, income and other requirements determined by your lender.
-- Eligible income. How much money you earn and the sources of your income also matter. "When it comes to what income qualifies for the refinance, rental income may not," Tayne says. In fact, lenders may be skeptical of money made from rent unless you're a professional property owner. To increase your chances of approval, it helps to have about six months' worth of payments set aside in the bank, so the lender knows you can keep up even when your property is vacant.
-- Debt-to-income ratio. Finally, your debt-to-income ratio will also be considered in a rental refinancing lending decision. As with a traditional mortgage, lenders will want to verify that you aren't overextending yourself by taking on too many debts. The lender will calculate your total monthly debt obligation divided by your monthly income to determine your DTI. In general, you'll need a DTI under 50%.
[Read: Best Adjustable-Rate Mortgage Lenders.]
Steps for Refinancing a Rental Property
The process for refinancing a rental property is similar to refinancing a traditional mortgage. Knowing the steps ahead of time can help you prepare and keep the ball rolling.
1. Gather your paperwork. You'll need to collect all of the documentation outlined above and have it ready for your lender to review. Missing or outdated documents could delay the application process.
2. Submit your application. When you're ready with all the information you need to apply, it's time to submit the application. Usually, this can be done online. Be sure to keep your eye out for messages from the lender so you know next steps.
3. Lock in your rate. Once your application has been reviewed, the lender will (hopefully) approve it and give you an offer. You should review the terms of the offer and compare it with a few other quotes. Pay special attention to the interest rate and fee schedule. If you're happy with the offer, you should lock in your rate right away. If you don't, the rate offered could increase. Rate locks typically last between 30 and 60 days, but it depends on the particular lender. Be sure to find out so you can wrap up the application process before the rate lock expires.
4. Wait for underwriting. After you've accepted the offer, the lender will begin the underwriting process. This involves examining all of your documentation and verifying information such as income, assets and the condition of the property. The underwriting step is by far the longest; it could take several days to a few weeks.
5. Close the loan. Once underwriters have given the clear to close, you'll meet with your lender to go over the final contract, pay the closing costs and make the refinance official. Typically, it takes 30-45 days to go through the entire refinancing process, though sometimes it can extend to 60 days if you experience any hangups.
[Read: Best Mortgage Lenders.]
Can I Cash-Out Refinance a Rental Property?
If your goal of refinancing isn't necessarily to lower your mortgage interest rate but rather to cash out on some of your property's equity, that's also possible.
"These types of refinances are becoming more and more popular," Tayne says. "They can help you earn more rental income if you're using the cash you're taking out to make improvements to the rental property."
Even so, taking equity out of a rental property poses a lot of risk, so expect lenders to be skeptical. Again, if borrowers fall on hard times, lenders assume they will make the mortgage payments on the house in which they live first, meaning the rental property would be in greater jeopardy. It's a risk you'll have to weigh carefully.
"The only time I think it's worth tapping into the equity in a rental property to pull cash out is if you plan to use that cash to invest in a new rental property," Davis says. "Even then, I'd recommend that investors consider cross-collateralizing instead."
Cross-collateralizing means putting your rental property up as collateral when taking out a loan to buy a new rental property. Instead of collecting a down payment, the lender puts a second lien against the property with equity.
"They (lenders) get the extra protection, and you don't have to refinance," Davis says.
[Read: Best Home Equity Loans.]
Are There Downsides of Refinancing a Rental?
Refinancing can either save you a lot of money and help you earn more rental income, or it can end up being a bad deal for a couple of reasons.
For one, refinancing usually requires several thousand dollars in closing costs, which are usually at least 2% of the loan amount.
Lenders will often roll these costs into the loan principal for convenience, but it also makes it tougher to understand the true cost of refinancing. "Borrowers tend to disregard the fact that they just spent thousands of dollars simply because it didn't come out of their checking account," Davis says.
The truth is that closing costs, and the extra interest you pay on them if they're rolled into the loan, can easily wipe out any savings you reap by getting a lower interest rate.
The second potential issue is that refinancing resets the amortization schedule. When you take out a loan, you pay most of the interest in the beginning.
"Most of your monthly payment goes to interest, and very little goes toward paying down your principal balance," Davis says. "The further you get along your loan term, the more of your payment starts going toward principal."
When you refinance, you reset the schedule, and your payments go mostly toward interest again. It will take some time to build up equity in your property. Ultimately, it's up to you to crunch the numbers and decide whether refinancing your rental property is the right move.
Casey Bond is a seasoned personal finance writer and editor. Her work has appeared in a number of major national publications including U.S. News & World Report, Yahoo Finance, MSN, The Huffington Post, Business Insider, Forbes and others. Follow her on Twitter @CaseyLynnBond.
