The loan on a rental property may have a significant impact potential long-term return. Higher interest rates can take a big bit out of cash flow, leaving less money left over to pay for normal operating expenses or debt reduction.
In this article, we’ll explain five reasons why investors refinance rental property, explain the loan documents and refinancing requirements that mortgage lenders look for, and discuss how to prepare when the time is right to refinance a rental property.
- Investors refinance a rental property to obtain a lower interest rate, change the loan terms, and turn accrued equity into cash.
- Tips for preparing a rental property refinance include maintaining a good credit score, extending the tenant’s lease, and making any needed repairs.
- Lenders look at the property’s loan-to-value ratio and the borrower’s debt-to-income ratio when considering a rental property refinance.
- Five steps to refinance a rental property are organizing paperwork, submitting a refinance loan application, locking in the interest rate, underwriting, and closing on the rental property refinance.
Why investors refinance rental property
Although many real estate investors buy and hold rental property for the long-term, that doesn’t mean that the loan has to stay the same from beginning to end. In fact, making changes to financing may help to increase cash flow and scale up to grow a rental property portfolio.
Here are some of the main reasons and potential advantages for refinancing a rental property:
- Lower the loan interest rate and monthly mortgage payment amount.
On a $150,000 loan, lowering the interest rate by 0.25% saves about $240 per year. That extra savings from refinancing to a loan with a lower interest rate can be used to pay down the existing loan balance faster.
- Shorten the mortgage term.
Most conventional loans on an investment property offer a term of 30 years. By shortening the mortgage term from 30 to 20 years, an investor can save a significant amount of money spent on interest expense. On a $150,000 loan, an investor could save nearly $40,000 through the life of the loan by changing the mortgage term from 30 to 20 years, assuming a mortgage interest rate of 4.0%.
- Turn equity into cash.
The faster the mortgage principal balance is paid down, the more potential equity there is in a home that can be pulled out via a cash out refinance and used to purchase additional rental property. Home equity can also increase (or decrease) based on the change in property values depending on the phase of the real estate cycle.
- Increase rental income and property value.
Cash pulled out when a home is refinanced can also be used to renovate and improve an existing rental property to help increase the monthly rental income. According to the tenant screening service company RentPrep, the top amenities tenants look for in a rental property include a washer and dryer (or hookups), air conditioning, patio, hardwood floors, dishwasher, fireplace, and walk-in closets.
- Lower personal debt-to-income ratio.
Money received when a rental property is refinanced can also be used to pay down or eliminate personal debt such as a student loan or a high-interest car loan. Most real estate investors use their personal credit history to apply for a rental property loan. By lowering the personal debt-to-income (DTI) ratio, an investor may be able to receive a lower interest rate and better loan terms when financing a rental property.
Tips for preparing for a rental property refinance
In order to help increase the odds of being approved for a refi, investors should plan ahead and prepare before committing to refinancing a rental property.
Some tips to follow that may help to get a lower rate and better terms on a refinanced loan for a rental property by making a good impression on the lender include:
- Maintain a good personal credit score of at least 620 by avoiding taking on new debt and keeping current on existing credit lines.
- Consider extending the existing tenant’s lease if the expiration date is coming soon to show a lender that rental income is more predictable.
- Multifamily property owners should lease-up any vacant units before applying for a rental property refi.
- Make any needed repairs to help the rental property appraise and any inspection required by the lender to come back problem free.
- Pull copies of the last two years of tax returns, including Schedule E (Form 1040) to show rental income and expenses.
- Prepare rental property documents including copies of the tenant lease, rent roll, prior year and year-to-date income statement, and a capital expense report showing any recent improvements made to help increase the property value.
Last, but certainly not least, be prepared to shop around for a rental property refinance loan.
Investors can speak to a mortgage broker who has access to a variety of loan programs offered by different lenders, or check out Stessa Mortgages to receive a free rate quote from an experienced mortgage professional.
How to refinance a rental property
Refinancing a rental property can be more complicated than a traditional mortgage on a primary residence, so it makes sense to plan in advance.
Investors can begin by understanding lender loan requirements, organize documents before applying for a loan, then follow the five steps for a rental property refinance:
Lender refinancing requirements
Good credit score: A credit score is used by lenders to help decide how likely a loan is to be repaid on time. While most lenders will approve a rental property refinance for a borrower with a credit score of 640, a credit score of at least 700 may help an investor to get better loan terms and a lower interest rate.
Higher interest rate: Even with a high credit score, lenders view loans on rental property and rental property refis as having more risk than a primary residence, because rental property is used for business purposes. As a rule of thumb, interest rates on a rental property refinance may be between 0.5% and 0.75% higher than the mortgage on an owner-occupied home.
Debt-to-income ratio: From a lender’s point of view, the lower a borrower’s debt payments are in relation to income, the lower the risk is of a borrower becoming overextended by taking on too much debt. Debt-to-income (DTI) ratio is calculated by dividing the total monthly debt payments by the total monthly income. Lenders normally look for a DTI of less than 43% in order to qualify a borrower for a rental property refinance.
Eligible income: Some lenders do not include income earned from a rental property when calculating a borrower’s debt-to-income ratio unless the property has a consistent history of being occupied with tenants who pay the rent on time. Lenders often ask investors refinancing a rental property to hold six months of mortgage payments in a reserve or escrow account. Having cash reserves lets the lender know the mortgage will be paid even if the property is vacant for longer than expected.
Loan-to-value ratio: In most cases, a lender will require a maximum loan-to-value (LTV) ratio of 75% to approve a refinance loan for a rental property. LTV is calculated by dividing the loan amount by the property’s appraised value. For example, if a rental property is worth $150,000 and the requested loan is for $100,000, the LTV would be 66.7%.
Personal & rental property documents
There is also more paperwork involved when refinancing rental property.
Fortunately, rental property financial management systems like Stessa that offer free cloud-based document storage make it easy to organize, store, and access documents that lenders need when underwriting a rental property refi:
- Proof of borrower income, such as a recent pay stub or bank statement if self-employed.
- W-2 forms to help verify employment history and income.
- Proof of homeowners and title insurance on the rental property.
- Last two years of personal federal tax returns, with all pages, including Schedule E (Form 1040) reporting rental property income and expenses.
- Current lease and rent roll for the current tenant showing rent payment history, security deposit, and amount of time left on the existing lease.
- Recent financial statements from the rental property being refinanced, such as income statement, net cash flow, and capital expense report.
- Recent bank, retirement, and investment account statements to verify that borrower funds are available to credit toward any reserve requirement.
5 steps for a rental property refinance
After reviewing a lender’s rental property refinance requirements and gathering and organizing loan documents, borrowers follow these five general steps to apply for a rental property refi:
- Collect and organize paperwork and loan documents to make a good first impression with the lender.
- Submit the loan application for the rental property refinance and wait for a response from the lender to understand what to do next.
- Consider locking in the interest rate for the rental property refinance when the loan is approved, and review it with rate quotes from other lenders, remembering that rate locks on interest rates usually last no longer than 30 or 60 days.
- Underwriting begins once the borrower has accepted the rate and loan terms of the rental property refi and could take several weeks for loan documents to be reviewed and information to be verified.
- Close on the rental property refinance loan once underwriting is completed, pay any required closing costs, and expect any cash pulled out of the property with the rental property refi to be received once the loan is recorded, normally within one or two business days.