What Is Refinancing: A Definitive Guide to Refinancing Your Rental Property
Don gets up from my dining room table and packs up a large file of papers. Since COVID is in full effect he reaches over the table masked and holds out a fist. “Congratulations Kevin!” I smack his fist with mine.
I just closed my third refinance in a month as rates hit record lows, again. This one is saving me another $300 a month further increasing my cash flow on another rental. I close the door behind him and realize that I just gave myself another raise. Man I love this business!!
What is a Mortgage Refinance?
A mortgage refinance is very simply putting financing on a property that you already own.
What are the Different Types of Refinance Loans?
There are multiple reasons an investor would refinance their rental home and several different types of refinance loans to consider.
Rate And Term Refinance
A rate and term refinance is replacing existing debt on a property with new debt. The purpose of a rate and term refinance is to change either the rate of your loan or one or more of the terms. This is the refinance loan that I am using to lower my monthly payment and increase my cash flow.
A cash out refinance’s primary purpose is to pull cash out of the property. For most lenders, if the borrower gets $2,000 or more, they will consider the loan a cash out refinance. These loans are riskier to the lender so the terms and qualifying guidelines are different. These loans normally come with a higher rate. The advantage, of course, is liquidating some of the equity in the property so you can invest in other projects, make improvements, or consolidate debt.
A cash-in refinance is just as it sounds. You will be putting money into the deal to get the refinance done. I know it sounds crazy, but you might consider this if you have a specific payment target you are trying to hit or are trying to improve the terms of your loan. I recently refinanced my primary home as well as several rentals. For my primary home refinance, I brought money to closing so I could stay under conventional loan limits which gave me the best terms in the market. Also, by reducing my loan amount, I created more equity in my home, allowing me to increase the size of my current HELOC.
This strategy gave me the best possible rate and terms on my first mortgage without losing access to the money but it was a combination of the refinance and working with my bank to increase the HELOC.
Fixed Rate Refinance
Whether you are doing a rate and term, cash-in or cash-out refinance you will have the option of a fixed rate loan or adjustable rate. A fixed rate loan is the safest for you as your rate will not move. The only reason your monthly payment would change is if there was a change in your taxes, insurance, or other monthly obligations. In most cases I would recommend a fixed rate, especially in a low rate environment like we are in today.
Adjustable Rate Refinance
Adjustable rate mortgages (ARMs) are not as simple. There is a slew of different adjustable rate loans that you can consider. These loans are called adjustable rate because the rates will bounce around depending on the loan terms. All adjustable rate loans are based on an index and have a margin added to it. Prime and LIBOR are the two most common indexes and these index rates are published and made public. Margins could range from .25% to 2 or even 3%. If your index was 3% and your margin was 1%, your loan interest rate would be 4%.
Many adjustable rate loans can come with fixed rate periods. For example you might have a loan that amortizes over 30 years, the most common length for a mortgage loan, but the loan is only fixed for the first five years. After the first five years the rate is subject to change and will change based on the agreement. That could be once a year, twice a year or even every month. The fixed rate periods range from 2 year to 10 years. Although there is a fixed rate period, this is considered an adjustable rate loan.
Having a rate that adjusts shifts risk from the banks to the borrower. If rates increase, the rate on the loan increases so the lender can keep their loan at market rates. With a fixed rate loan, when the rate increases the bank loses out on the opportunity to loan that money out at the higher rate. It is because of this shift in risk that lenders offer better rates on adjustable rate loans. You would consider an adjustable rate loan if you don’t plan to keep the loan very long. This is especially true if you can fix your rate for the period you plan to have the loan and allow it to adjust when you are ready to refinance or sell. Using a loan like this will give you a better rate, potentially saving you thousands of dollars.
The Benefits of Refinancing Your Mortgage
You would only consider refinancing your rental property if it helped you. Here are some of the ways a refinance can benefit you.
Lower Your Mortgage Interest Rate
I think this is the most common reason you see real estate investors refinance. Although this is not always a good thing, which we will discuss below, lowering your interest rates typically saves you money. The amount of money you pay in interest to your lender is directly tied to the rate so obviously we want to get a lower rate when we can.
Reduce Your Monthly Mortgage Payments
One common benefit of a lower rate is a lower monthly payment. There are many ways to reduce your monthly payment, which is why we want to look at more aspects of a loan than just interest rate. Cash is king and cash flow is the most important aspect to longevity. If you plan to be in this business and grow true wealth, I recommend increasing cash flow as much as possible, especially as you are getting started. Once your cash flow is in a comfortable position, you can shift focus to reducing debt or your other investing goals. Without positive cash flow, however, you won’t have a business so refinancing to lower your payment can be an excellent step forward with your real estate investing career.
Shorten the Length of Your Loan Term
If one of your goals is to pay off real estate, shortening your loan term will speed you up. If you are able to get a better interest rate, it is possible to shorten the term without increasing your payment but in most cases you will see an increase in your monthly payment. Typically you will see better interest rates for shorter term loans. This comes back to risk again. If a larger portion of each of your payments is going to principal, the loan carries less risk and the lender can offer a better rate. Keep an eye on this when you are shopping loan terms with your next refinance.
Consolidate Multiple Loans
Several years ago, I combined 3 of my rental properties into one loan with a local commercial bank. I did this because I had one loan for three properties and was able to get the loans off my credit. Many commercial banks will not report commercial loans to personal credit. This helped me increase my credit score and reduce the number of financed properties on my tax returns.
Consolidating multiple loans does not have to be limited to mortgages, however. If your goal is monthly cash flow you can potentially combine credit card debt, car loans, or other obligations into one loan secured by a house. This would likely improve the rate on the other obligations and will extend the term which could drastically improve your monthly payment. Be careful here; turning a 5 year car note into a 30 year mortgage significantly increases the time you will carry that debt.
Change The Loan Structure
When we talk about rate and term refinances it is almost always about lowering the rate or extending the term to lower the payment. There are many other reasons you might want to refinance a loan. For example, if you have an ARM and plan to keep the house forever, you might consider taking a slightly higher rate now so you can lock that rate in for the life of the loan.
In some cases you might be coming up to a maturity event or want to avoid extension fees. These or a number of other terms inside a loan can be handled by simply paying off the lender through a refinance.
Repurpose Your Equity
The interest you earn on equity in property is zero percent. Equity in a property can have advantages like a warm fuzzy when you go to bed or increased cash flow on that one property but it does not accelerate your growth. Although it carries some added risk, most investors in the growth phase of their investing will want to leverage their properties to continue investing. Freeing up untapped equity with a refinance can create many benefits for you including:
Pay Off Balloon Loans
A balloon is when the full balance of a loan is due. This is extremely common with commercial loans, even if those loans are secured by residential property. You will also see balloon dates with hard money lenders and most private money investors. Going past a maturity date, or balloon date, can be extremely costly. In most cases it would cost you an extension fee and maybe a higher rate but it could cost you the house. Be careful with balloon notes and be sure you have a plan to pay it back. Even if that means using equity from other properties.
Obtain Cash For Financial Emergencies
COVID was a great reminder of the importance of reserves. Many of my friends and family members that lost work went through an extremely tough time. I had tenants calling me for support and the default rate on loans went through the roof. This is all because these families did not have enough reserves to weather a storm. Obviously COVID was, still is, quite the storm, but that does not negate the fact that smart real estate investors carry reserves.
Because refinances can take a while to close it might make sense to get a line of credit or do a cash out refinance to establish the reserves before you need it. A banker once told me, “it is a lot easier to get money when you don’t need it.”
Invest in Home Improvements
Do you have an unfinished basement that can increase your bedroom and bathroom count or can you add a garage or a shed or something else that you can rent out? If you can improve your rent by improving your property, it is something to consider. I would look at the overall cost of the money, the increased monthly payment, and the monthly rent increase. If you can refinance a rental property and increase cash flow it might make sense to do it. I don’t typically consider the increase in the property value when looking at improvements on rentals but that is also a benefit you will capture when you sell.
Invest in Additional Real Estate
This is the biggest reason I say equity in a property slows your growth. Real estate is such a fantastic investment, it probably makes sense to invest in more quality properties if you can.
What are the Drawbacks of Refinancing Your Mortgage?
Although you would not refinance a rental property unless you benefited, refinance could also have some downside.
You May Not Qualify for Better Terms
The first step in your refinance process is to connect with the lender and be sure you qualify and what you qualify for. Lenders’ loan appetites can change, especially with smaller banks, meaning the terms for certain types of loans will change. Pricing gets worse for loans they do not want in their portfolio. Be sure you qualify for the terms you want and that you will benefit from doing the refinance.
Upfront Costs of Refinancing Can Be Expensive
A refinance is normally not free. The lender needs to be paid for originating the loan and you will likely have appraisal costs and closing costs. This is ok and expected but you need to understand the costs and analyze if the costs are worth the benefit. On one of my recent refinances I paid the closing costs out of pocket and got a better rate and lower payment. The break even on that loan was almost four years, meaning it will take me almost four years before my monthly savings is more than what it costs me to refinance. Typically, I would not take a break even that far in the future but this specific house will likely be in my portfolio forever and I don’t think I will have a chance at these rates again. For me locking in that rate was enough benefit to pay the cost so I moved forward with it.
Higher Lifetime Cost Of Borrowing
There are more costs to a loan than just the origination fee and closing costs.
Lower Monthly Payments vs. Longer Loan Terms
If you have ever looked at an amortization schedule you will notice that most of your principal is paid in the later part of the term. As you work your way through the amortization, you significantly reduce the amount of interest you pay the lender. For this reason it is not always a great idea to refinance and restart your full amortization. Extending the term will not only slow down the time it will take to pay off your property, it will significantly increase the interest you pay over the life of the loan. If your goal is cash flow, this might be smart but be sure to look at more than just the monthly payment.
Private Mortgage Insurance
This will likely not be a concern today but if we see a reduction in values, you might get slapped with mortgage insurance if you refinance. Typically, you will see mortgage insurance on loans with higher loan to value. For rental properties, this would be loans that are higher than 80% of the property value. If you are close to this, be sure to check with your lender and ask about mortgage insurance so you don’t miss this expense when deciding on a refinance.
Losing The Beneficial Provisions Of The Previous Loan
It is possible that you have a great provision in your current loan that you would not want to lose. For example, there was a time where most government loans were fully assumable. This means that you could sell the house to a new owner and keep the loan in place by having the new owner assume your position as the borrower. This was great because the new owner would already be several years into the amortization schedule which gives them a huge head start in paying off the loan. Although you don’t see many assumable loans any more, there may be other provisions that you would not want to lose, like a fixed rate, a higher loan to value, interest only, or a number of other favorable terms.
Refinancing Can Be a Lengthy Process
Appraisals and lenders are backed up. With the decreasing interest rates, there have been waves of refinances. Lenders are also requiring more documentation now then ever before, further slowing the underwriting process. Even with this slow pace, it is probably still worth being patient if you are getting a benefit from the refinance.
How to Refinance Your Rental Property
As mentioned, there are several different loans to choose from depending on what you are trying to accomplish. Different lenders will provide different options. The process is rather simple if you have the right team around you. You would want to call a lender you trust and explain to him or her your goals and get advice on the correct loan. A trusted lending adviser would tell you if your best option is with another lender.
Refinance Your Mortgage Through a Traditional Lender
This will be your most common path. When shopping for a lender I would ask if they are a direct to Fannie or a direct to Freddie lender. The reason I say this is if they sell the loan direct, they will have more flexible underwriting and likely better interest rates. Many lenders are simply brokers, meaning they broker someone else’s money who in turn will sell the loan. Brokers add another layer of complexity with possible tighter guidelines and higher prices.
Brokers are not all bad though. If your loan does not qualify for Fannie Mae or Freddie Mac, a broker would be your best option because they have many different lenders they can go to with your loan to get you the best option available.
Banks can also be a great option as many banks hold their loans in their portfolio. These are considered portfolio lenders. The great thing about portfolio lenders is they have their own guidelines so they can get tricky deals closed. It is worth a call to a handful of banks on the tough to close refinances.
Obtain a HELOC Loan
I absolutely love home equity lines of credit. The reason I love these is they give you access to the cash but you are not paying interest until you use it. With the tightening credit we have recently experienced, these are getting harder to find. Conventional lenders simply won’t do them so you will be forced to go through your bank or credit union.
One downside to these is they are all adjustable rate loans so you will not be able to lock in an interest rate.
Consider a Mortgage Recast
Although rare, a recast might be the best option for you to accomplish your goals. A recast is when you re-amortize your loan. For example, let’s say you are 5 years into a 30 year loan. A recast might push that loan back out to 30 years, leaving the rest of the loan terms alone, which would increase the time you have the loan but decrease your mortgage payment.
In most cases a lender will only consider a recast if you are putting a chunk of money down reducing the lender’s risk in the loan. With that said, we will likely start seeing more recasts as we work our way through the COVID pandemic. Banks are far more likely to recast loans if they believe the borrower is in financial trouble.
Obtain a Hard Money Loan
Hard money loans are primarily used to buy and rehab houses. It is rare to see a hard money loan used as a refinance but there are times it would make sense. For example, if you are up against a balloon payment and need to close fast, or if you are in the middle of a rehab and need more time or money to get to the finish line. In those cases, a hard money loan might be the only option. Most lenders will not loan on a home that is in the middle of a remodel. They would want all work complete and all permits closed out.
Is Refinancing Right For You?
As you can see, there is a lot to consider when deciding if refinancing is the right move for you. The best advice would be to call your trusted advisors and ask them what options are available. If you have a goal in mind, that would help the people you trust guide you in the right direction.