In certain circumstances, refinancing a rental property can be a very smart move. It can allow you to better tailor your mortgage terms to meet your financial goals, whether that’s reducing your monthly payments, saving money over the life of the loan, or accessing cash to renovate or buy other properties.
However, refinancing (aka “refi”) isn’t the right move for everyone. There are costs and risks, so it’s important to understand what you’re getting into before you commit. You’ll need to know the right questions to ask potential lenders to be sure the cost-benefit factors are right in your particular situation.
Finally, refinancing an investment property is a bit trickier than refinancing a mortgage for your primary residence, so you’ll want to be prepared for the higher bar you’ll need to clear in order to qualify.
This guide will help you understand:
- The benefits of refinancing a rental property
- The risks and costs of refinancing
- What lenders look for
- How an investment property refi differs from refinancing your primary residence
When to Refinance a Rental Property
Refinancing means replacing one debt obligation with a new one, with different terms. When you refinance, your existing mortgage will be paid off and you will have a new loan in its place.
The point of refinancing is to change the terms of your loan to better suit your financial needs and goals. Terms of the loan you may wish to change include:
- The interest rate
- Variable interest rate to a fixed interest rate
- The repayment period
- The minimum monthly payment
- The amount of money you are borrowing
Let’s go over each of these items individually to see what benefits a refinance can provide when it comes to each of these loan terms.
Potential Benefits of Refinancing
Lowering your interest rate
Many borrowers refinance in order to attain a lower interest rate. Interest rates fluctuate with large-scale economic changes – perhaps you took out your original mortgage when interest rates were higher and now they’ve dropped. Refinancing allows you to reset your loan terms according to current, lower interest rates.
Or, maybe your credit score has improved substantially since you made your initial real estate investment. This might also earn you a lower interest rate if you refinance.
Converting from a 30-year to a 15-year or 10-year mortgage term can allow you to reduce your interest rate as well if you can handle the higher monthly payments. Shorter loan terms (repayment periods) generally carry lower interest rates.
Finally, there is a scenario in which the interest rate on your mortgage has gone up if you have a variable-rate loan. Refinancing into a fixed-interest rate loan may lower your interest rate, along with providing other benefits. More on that in the next section.
Converting from a variable to fixed interest rate
If you bought your rental property using an adjustable interest rate mortgage, you may wish to refinance into a mortgage with a fixed interest rate for greater stability.
Adjustable-rate mortgages are riskier than fixed-rate mortgages. They start off with below-market interest rates and then fluctuate according to the specific loan terms over time. In some cases, interest rates can jump enormously over a short period, raising minimum monthly payments beyond what the homeowner can afford (subprime adjustable-rate mortgages led to many foreclosures during the Great Recession).
Sometimes a buyer opts for an adjustable-rate mortgage because of the low initial interest rate, expecting their income will increase or that they would sell the property before the interest rate adjusts. If this bet on future circumstances doesn’t pan out as planned, the homeowner may end up saddled with far higher monthly payments than they want or can handle.
In this situation, refinancing may allow a property owner with a variable-interest-rate mortgage to switch to a far more predictable and less risky fixed-rate mortgage.
Reducing the minimum payment amount
As in the above example, switching from an adjustable-rate to a fixed-rate mortgage may help reduce minimum monthly payments or prevent them from increasing dramatically when the interest rate changes.
Property owners with existing fixed-rate mortgages may have the same goal: reducing their monthly payment amount. Refinancing into a new mortgage with a longer repayment period, lower interest rate, or both may help to reduce the monthly minimum payments on the loan.
Just be aware that if you increase the repayment period to lower your monthly minimum payments, the loan will end up costing you more in the end, since you’ll be taking longer to pay it off. For this reason, you should refinance to reduce your monthly payments only if you have a good reason to do so – i.e. if your monthly payments are truly unaffordable, or if you have a plan to use the money you’ll save on monthly payments for another investment that will increase your cash flow, pay down higher-interest debt, etc.
Adjusting the amount of time you have to pay back the loan
Since shorter loan terms generally carry lower interest rates, reducing the term of your mortgage from 30 years to 15 or even 10 years can significantly lower your interest rate. You will also pay off your loan faster and spend less overall with less interest to pay off.
However, the tradeoff for shortening your loan term is higher monthly minimum payments. If you can swing it – for instance, if your income has gone up significantly since you first bought your rental property – this can be a smart move.
Other property owners may wish to extend the amount of time that they have to pay back the loan, thus shrinking their minimum monthly payments and freeing up cash for other things. Again, you should weigh this move carefully, since it will likely increase the overall cost of the loan and it will take longer for you to pay off the debt.
Allowing you to borrow more money
A cash-out refinance allows you to turn some of your property’s value into cash that can be used for other things. Maybe you want to remodel your rental property so that you can charge higher rents, make a down payment on another investment property, or pay down higher-interest debts like credit card balances. All of these may be motivations for a cash-out refinance.
A cash-out refi is similar to a home equity loan or line of credit in that it allows you to liquidate some of your equity in the property. The difference is that a home equity loan exists alongside your mortgage as a separate debt obligation, whereas a cash-out refinance replaces your mortgage with one new, larger debt obligation.
The interest rate for a cash-out refinance may be lower than for a home equity loan; however, as with your original mortgage, there are closing costs for a cash-out refinance. Lenders are much more hesitant to provide home equity loans on investment properties than on primary residences, so a cash-out refinance may be your only option.
Here’s an example of how a cash-out refi might work. Say you owe $50,000 on a property currently valued at $150,000. That gives you $100,000 in equity. If you did a cash-out refinance for $80,000, you would go from owing $50k on the property to owing $80k on it instead. This means your equity in the property would decrease from $100k to $70k, and you’d receive the difference — $30k — in cash.
Since a cash-out refinance results in a larger debt obligation than you had before, it’s important to do this only when you have a sound reason to do so.
Recap: the possible benefits of refinancing
To sum up, refinancing your rental property may provide you with the following benefits:
- A lower interest rate
- Faster loan payoff
- Saving money over the life of the loan
- Reducing risk by switching from an adjustable interest rate to a fixed one
- Lower monthly payments
- Turning equity in a property into cash you can use now
Costs & Risks of Refinancing
Refinancing is a tool that in the right circumstances can help you reach your financial goals. However, like any tool, it can also do more harm than good when used carelessly or in the wrong circumstances.
The following are some of the costs, risks, and potential downsides of refinancing an investment property.
Refinancing carries closing costs that can range from hundreds to thousands of dollars — general guidance is that closing costs on a property refinance represent 3 to 6 percent of the loan principal.
These cover the costs of an appraisal, application fees, and title search, similar to what your initial mortgage required. Some lenders may allow you to wrap the closing costs into the loan, but this approach raises your debt obligation and monthly payments.
It’s therefore important to be sure that the benefits you will see from refinancing are worth the costs.
If you are considering refinancing primarily to free up more cash now, either through lower monthly payments or to borrow against the equity you’ve built in your property with a cash-out refinance, then it’s possible the transaction will cost you more in the end. That’s because you’ll likely have a longer repayment term and pay more interest over the life of the loan.
Whether this move is worth it or not depends on what you’ll be using that additional short-term cash for in the meantime – e.g., investing in another property, paying off higher-interest debt, remodeling, etc.
It’s important to keep in mind that in any of these cases, your risk is increasing. You’re trading more cash in the short-term for an uncertain future outcome. If your future financial security depends on you making the right bets, refinancing may be too risky.
For example, many people who refinance to pay off higher-interest debt think the move makes sense. They’re trading in higher-interest debt such as credit card debt for lower-interest debt. That being said, it’s often not that simple.
If your spending habits are the root problem and those don’t change, you may end up back in high-interest credit card debt again following a refinance. This may put you in a worse position than you started with. In this scenario, the refinance may allow you to simply get in more debt than you could have otherwise.
How to Proceed with a Rental Property Refinance
If you want to explore refinancing rental property, be aware that the process can be a bit trickier than with a refinance of your primary residence.
Lenders typically consider loans for rental properties riskier bets and therefore set the bar higher for borrowers. Your interest rate will generally be higher for an investment property than for your primary residence.
In determining whether you qualify for a rental property refinance, a lender will likely want the following information:
- Your credit score. Generally, a minimum of 620 is generally needed to qualify for an investment property refi. A higher credit score will earn you a better interest rate.
- Proof of income.
- Your debt-to-income ratio. Forty-three percent is the maximum most lenders will allow for a rental property refi.
- Documentation of your current mortgage.
- The loan-to-value ratio. A lender will look for a minimum loan-to-value (LTV) ratio, referring to how the loan amount you’re asking for compares to your equity in the property. 25 percent equity or an LTV ratio of 75 percent is a typical minimum for investment property refinancing. (An appraisal is required to determine the property’s current value.)
- Recent bank statements. A lender may want to see enough money set aside to cover several months’ worth of mortgage payments in the case of a rental property vacancy or tenant nonpayment of rent.
- Recent tax returns.
- Documentation of rental income, including leases and proof of payment.
- Proof of homeowner’s insurance.
Gather as much of this documentation as you can as early as possible in the process, and be prepared to respond to other requests for information quickly from lenders.
Shop around to find the best deal. You may want to start with your current mortgage lender, but also check credit unions and other banks. Be sure to ask detailed questions about closing costs.
The Bottom Line
Refinancing your investment property may be the right move in some cases, especially if it lowers your interest rate or allows you to pay off your mortgage faster. If it doesn’t, proceed with caution and ask yourself whether the long-term bet you’re making is worth the risk.
As with any major financial move, be sure to shop around to find the best deal, ask detailed questions, and read the fine print before committing.