As you manage your rental properties, you want to come back to the bottom line and make sure you are making every effort to maximize profits. Every month, if you are working from the same circumstances as many other rental property owners, you are trying to minimize payments, including your mortgage, and maximize rental income by keeping the property rented consistently. Many people turn toward refinancing the loan on their primary residences in order to get a lower interest rate or a lower payment each month. Certainly, when you refinance, the loan "clock" starts over, so you may be paying over a longer term, but if you have a new interest rate, the total cost of the loan could go down.
Many people assume that if their primary residence would benefit from a refinanced loan, their rental property would benefit as well. After all, it is true that a lower monthly payment will increase your cash flow from the rental income you are bringing in. However, there are a few additional concerns that banks have about refinancing loans on rental property. This means that you should evaluate carefully and ensure that your situation actually results in a benefit.
Investment Property Refinance Interest Rate Factors
Before you commit mentally to the idea of refinancing, you'll want to shop around, talking to different lenders about the kinds of favorable terms they can offer. You may immediately realize that the initial costs of refinancing or the terms offered aren't enough to make financial sense, but it is free to do your homework and figure out the lay of the land. Take into account, even before you approach banks and other lenders, the context of investment property refinancing.
Investment Property Versus Primary Residence Interest Rates
One sad truth is that loans on investment properties are considered riskier than mortgages that are on a primary residence. Whether this is fair or not, banks are probably correct that most people would "save" their primary residence at all costs to avoid losing a family home, while losing their investment property when caught in a bad situation would seem less dire. In order to compensate for the added risk of default on the loan, these interest rates tend to be a little higher. When interest rates are rock-bottom, the slightly higher rate to refinance an investment property (usually somewhere around 0.5 percent higher) may still be worth it compared to when you first took out the loan. However, just seeing great interest rates on primary residences (or hearing friends talk about them) doesn't guarantee that you'll get those kinds of rates when you refinance.
Loan-to-Value (LTV) Ratio
Your Loan-to-Value Ratio is a constantly changing ratio that gives a current expression of how your equity relates to your loan. For instance, if you own a building worth $250,000 and you still have $150,000 to pay, your LTV is a pretty reasonable 60%. The problem happens when this ratio flips; your property value drops faster than your payment, and say you have $250,000 left to pay on a property appraised at only $200,000; your ratio is now 125%. The LTV Ratio you must have with an investment property is lower than for refinancing in other contexts; you want to have substantial equity in your building before you'll be considered a good candidate for a refinanced loan with a lender. Aim for 75% or lower LTV ratio to be attractive to lenders; if you are close, you can always speak to a variety of lenders, but they may say that you should wait until you have more equity before trying to refinance.
You don't have to be told that you need a solid credit score to refinance; after all, it is a new loan that pays off your original loan, and for that someone will be checking in on your credit. Aim to get to at least a 660 score if you want to refinance for sure, but having a higher score, something more like 760, according to Zillow, can get you access to more favorable interest rates. Since every little bit matters when evaluating the value of refinancing, waiting until your credit score creeps up just a little more might make a big difference.
Liquidity In Case of Vacancy
Unlike personal home payments, many lenders will want to see that you have 6 months or more of your future mortgage payments saved up in case of a vacancy. In the eyes of your lender, the potential of a person moving out and leaving your home vacant is a problematic risk; you can calm their nerves by having liquid savings handy in the case of an unexpected vacancy. They know that it is in your best interest to get a new tenant, but they also want you to be able to cover the mortgage in all cases, even unexpected bad circumstances.
Why Start a Refinance (And Why to Hold Off)
Once you've gotten together the items you need, from your current credit score to your evidence of liquidity to pay the future refinanced mortgage, you'll want to crunch some serious numbers. Keep in mind that refinancing often costs a substantial chunk of change, between 3% and 6% of the principal of the loan, according to Investopedia. This means that you want savings that, long-term, save you more than that payment will save. Consider the following questions:
- If you are refinancing to gain access to the equity in your building, for another property's down payment, perhaps, how will you make sure that you stay afloat once you have both of these properties (in addition to anything else in your portfolio)? What are the benefits of aggressively pursuing more properties and the benefits of waiting until you've amassed more equity and capital?
- Is the new interest rate that much better? In the past, a 2% interest rate reduction was what made people comfortable saying that a refinanced mortgage made sense. Lately, lenders are saying it is more like 1%, but you should do the numbers for your own loan, its terms, and the terms you are offered by a refi lender.
- What are the benefits to you of having a longer term for your loan? Will you build equity faster with this new loan? Will your rental income be stronger, allowing you to reinvest in other properties faster?
- Do you have an Adjustable-Rate Mortgage and seek to lock in current low-interest rates with a Fixed-Rate Mortgage? Do the research you need to do in order to understand if rates are on a downward trajectory or an upward trajectory at the time of your refinance. The opposite is also possible; if you have a fixed rate that is absurdly high now, and you anticipate a continued downward trajectory, refinancing to an Adjustable-Rate Mortgage may make the most sense for your particular circumstance.
In general, the restrictive rules for getting a refinanced loan on rental property will help you avoid an ultra-risky loan, but you have to make the decision about what is worthwhile to you: after all, the lender wants to make sure that you are a low enough risk that they will make money, but that doesn't guarantee that you make money.
One way to think wisely about such choices is to think: what will the extra cash flow now do for me over the life of this loan? Will it be making me so much money that this refinance will be well worth it? If so, you might be ready to get started.
What to Gather
If you are ready to "full steam ahead" with your investment property refinancing, here are some of the things you'll likely need in order to move forward:
- Show them that you've got a rental lease and the rental deposit from the current tenants. Investment properties are much harder to refinance if they are currently vacant, even if you know you will find someone any day now.
- Evidence of all necessary insurance, be it HOA insurance or typical homeowner's insurance.
- Documentation of your financial situation: this involves your recent pay stubs and recent statements from your bank account, investment accounts, and retirement accounts. You'll also want your previous two years worth of tax returns.
- Finally, you need evidence from your current loan on what the expenses are on the property up till now, on a monthly basis, broken down into principal, interest, as well as taxes.
- Check with each individual lender to see what else they may need to move forward.
Even though the process can be complicated and expensive in the moment, refinancing your investment property can be a way to expand your property rental business and gain the necessary cash flow to, for example, jump on a really great deal on a new property you want to purchase. When you have your new lower interest rate and lower payment each month on your mortgage, make sure you make savvy choices as you purchase further properties that will retain their value long-term.
Ready to learn more about how VerticalRent can maximize your potential as a rental property owner? Contact us!