An 8% rental property mortgage may have seemed like a great deal 15 years ago. But rates have dropped like a rock, and your investment property’s kitchen and bathroom have seen better days.
Should you sell and start over? Not if you’re willing to refinance your mortgage.
Borrowers refinance their mortgages all the time, for many reasons. While you shouldn’t do it lightly, given all the costs involved, it serves as a viable option in your property owner toolkit.
How to Refinance Rental and Investment Properties
If you’re ready for a change in your rental property mortgage, follow these steps to make it happen.
1. Gather Your Documents
Like any mortgage, investment property loans come with huge paperwork requirements.
Plan on providing the following documents along with your initial loan application:
- Government-issued photo ID
- Property insurance declaration page
- Current mortgage statement
- Proof of income — typically two years’ tax returns or two months’ pay stubs, though some lenders don’t require income verification from investment property owners
- Current bank account statements
- Current brokerage account statements, including retirement accounts
- Business profit and loss statements, if applicable
- If the property is rented, a rental lease contract
- LLC or other legal entity documents, including articles of organization, operating agreement, and EIN, if applicable
- If required in the property’s jurisdiction, the rental property registration
Note that the requirements vary depending on the type of lender. If you approach a traditional mortgage lender — the kind that mostly writes mortgages for homeowners — expect them to ask for more paperwork. Expect the process to take longer as well.
Portfolio lenders, who keep the loans on their own books and often double as hard money lenders, require less documentation. In most cases, these lenders don’t require income documentation. Instead, they review the rent you collect and use a formula called Debt-Service Coverage Ratio (DSCR) to estimate your future cash flow.
Lenders calculate DSCR by dividing the monthly rent by the monthly principal, interest, taxes, insurance and association dues (PITIA). In general, they consider a DSCR above 1.2 as solid. Portfolio lenders use this metric rather than debt-to-income ratios (DTI).
Contact several lenders to start shopping around, comparing interest rates, points, and flat “junk” fees.
Bear in mind that most conventional mortgage loan programs allow a maximum of only four mortgages reporting on your credit history. That limits their usefulness for your first few properties, at most.
Portfolio lenders don’t typically place these caps, or report to the credit bureaus at all for that matter. In fact, they tend to lower their pricing for more experienced real estate investors. Check out Visio, Kiavi, and LendingOne as good examples of portfolio lenders.
While portfolio lenders often don’t require income documentation, they do still check your credit report. Pull your own credit report before applying, and get verbal pricing quotes when shopping around. Allow only your final choice lender to pull your credit report.
3. Lock In Your Interest Rate
Once you’ve chosen a lender, submit your full application with all documentation, and lock in your interest rate. The lender will then provide you with a written confirmation of your loan pricing, known as a Good Faith Estimate.
Your loan estimate is usually good for settlements within the next 30 days. Don’t give them any excuses to delay your loan beyond that 30-day window. Always respond to their requests for more documents immediately.
4. Go Through Underwriting
After you send your loan officer the completed loan application along with all the initial documents they requested, the loan officer typically orders an appraisal. Your loan file goes to a processor who organizes it and flags any missing information for the loan officer to ask you about.
When the appraisal and all other documentation is in your file, it goes to underwriting for risk review. Underwriters confirm that your loan represents an acceptable risk for the lender. Expect them to ask for additional documentation during the process and to review the property appraisal with a fine tooth comb.
If they feel comfortable with the loan’s risk profile, they approve it for settlement, and the loan officer contacts you to schedule a closing date.
5. Close on Your New Loan
As a real estate investor, you’ve sat through settlements before. And you know how cramped your hand gets by the hundredth signature.
Ask for a final settlement statement the day before closing. Review every single line carefully, particularly the fees. Do they align with the initial Good Faith Estimate document that the lender gave you? If not, what has changed? The new document should clearly spell out any deviations.
Also, double check that the title company didn’t collect money for property taxes or water bills that you already paid.
Mortgage Refinancing Requirements
To begin with, lenders cap the percentage of the property value that they lend you. They refer to this as loan-to-value ratio or LTV. If your property is worth $200,000, and they limit your LTV to 80%, that means the most they’ll lend you is $160,000.
For refinances, lenders determine property value based on the appraised value. For purchases, it’s the lower of either the purchase price or the appraised value.
Lenders also want to confirm you’ll still earn positive cash flow on the rental property, calculating DSCR.
Credit matters too, whether you borrow from a conventional lender or a portfolio lender. Expect higher minimum credit scores for investment property loans than for home mortgages. I know a few lenders who will go as low as 600 or 620, such as Civic Financial, but most require a minimum score of 660 or 680.
Finally, most lenders require you to have plenty of cash reserves at settlement. The industry standard is six months’ mortgage payments, although some lenders allow less, and a few require more.
Reasons to Refinance Your Rental Property
As a general rule, I discourage investors from refinancing their properties. It restarts your amortization schedule at Square 1, extends your debt horizon into the future, and costs you thousands of dollars in closing costs.
Still, there are times when it makes sense to refinance a rental property. Here are a few of the most common reasons why landlords refinance.
1. Lower Your Mortgage Rate
If you took out a mortgage when you had bad credit or when interest rates were far higher than today, you may now be able to refinance at a much lower rate. That could in turn boost your monthly cash flow or at least allow you to break even after pulling cash out of the property.
Calculate how long it would take you to recover the money you spent on closing costs with your interest savings. For example, if refinancing would cost you $4,000 in closing costs, and your new lower monthly payment saves you $100, it would take you 40 months to break even on the refinance.
Better yet, add together the entire life-of-loan interest for the mortgage refinance and all closing costs. Compare that number to the remaining interest due on your current mortgage. That’s the real apples-to-apples comparison, and you may just find that your current mortgage will cost you less in remaining interest than the combined interest and fees on a refinance.
2. Change Your Loan Term
If you initially bought your investment property with a 15-year mortgage, the property’s cash flow might not be as nice as anticipated. Most non-landlords don’t realize how many expenses landlords incur, from repairs and maintenance to vacancy rate to property management costs.
So, some landlords refinance their 15-year loan to a 30-year fixed mortgage to push their annual cash flow above water and stop losing money each year.
If you bought your property with a 30-year mortgage and are thinking about refinancing to a 15-year mortgage to pay it off faster, don’t. Just pay more each month toward your existing loan’s principal. You can also try these other tactics to pay off your mortgage early.
3. Convert an ARM into a Fixed-Rate Loan
Mortgage lenders prefer to lend adjustable-rate mortgages (ARMs) rather than fixed-interest loans. It gives them better protection against future changes in interest rates while creating an incentive for borrowers to refinance.
If you took out an ARM when you initially bought the property and the initially fixed interest rate is about to switch over to adjustable, consider refinancing to a fixed interest rate mortgage. Unless rates have fallen significantly since you bought the property, your new rate is likely to be higher than the old one.
4. Cash Out Home Equity
Investors often like to pull equity out of their properties and put it to use in other investments.
Most commonly, they pull out equity to put toward a down payment on a new investment property. That enables them to keep growing their real estate portfolios — and their monthly cash flow.
But property owners can also tap equity to fund renovations, either at the property being refinanced or another investment property. For that matter, they can put it toward some other type of investment, from stocks to real estate crowdfunding to real estate syndications. After all, if you can borrow money at 5% and invest it at 10% — the historical average of U.S. stock returns — it makes a winning strategy in the long run.
In fact, some investors cash out their equity rather than ever selling property. If you’ve already paid off the property in full, and you want an influx of cash, you could sell — but then you’d lose the asset. A cash-out refinance could be a more attractive alternative that allows you to keep the asset while earning monthly rental income.
5. Repay Investors
If you borrowed money from friends, family, or other private investors to fund your down payment, you’re likely to have a shorter repayment period than if you’d borrowed from a bank. When it comes time to pay them back, you might need to refinance the property to do so.
You can avoid this by funneling all of your monthly cash flow to these private investors before their loan is due. With diligence and a little luck, you can pay them back in full without having to spend thousands on refinancing.
As you explore creative financing options for investment properties, don’t forget that you can use primary residence financing in house hacking.
For example, say you buy a fourplex and move into one unit while renting out the other three. You take out a conforming loan with a far lower interest rate than you’d pay on a rental property loan. You make a 3% to 10% down payment with a Fannie Mae or FHA loan, rather than a 20% to 30% down payment.
After one year, you can move out of the property without violating the terms of your mortgage. Then you can do it all over again, quickly building a leveraged portfolio of real estate investment properties.
Yes, you pay a little money in private mortgage insurance (PMI). But as soon as you reach 80% LTV on your mortgage balance, you can remove it.
Just beware that the mortgage limit still applies, so you can probably only do this with up to four properties. After that, you’ll need to use investment property mortgages to finance your rentals.