How to refinance an investment property

An investment property can be a good way to generate regular income. Rental fees can defray or entirely cover your mortgage payment on a rental property, while providing some extra money in your pocket.

But just like a regular mortgage, an investment property mortgage comes with costs — ones that you might be able to lower through refinancing. Whether you’re looking to reduce your interest costs with a lower rate, pay off the mortgage sooner with a shorter repayment term or tap equity to make improvements to the property, you’ll have to follow a refinancing process.

Refinancing an investment property mortgage is similar to refinancing your mortgage on your primary residence, with some noteworthy differences. Here’s what to know about refinancing an investment property.

• What qualifies as an investment property?
• Reasons to refinance an investment property
• 6 steps to refinance an investment property
• Pros and cons of refinancing an investment property
• Can you use a cash-out refinance on a rental property?

What qualifies as an investment property?

An investment property is a house you buy with the intention of renting it out to make money. The rental could be long-term if you own a property in an area with high rental demand, such as the suburbs of a big city, or short-term if the property is located in an area that’s a vacation destination, like the beach.

Unlike your primary residence or even a second home, you won’t be living in your investment property. But as with your primary residence, you’ll typically have a mortgage on an investment property. Ideally, rental income will cover the cost of your mortgage, with some money left over as profit.

Reasons to refinance an investment property

Many of the reasons for refinancing an investment property mirror reasons for refinancing a primary residence, including:

• Get a lower interest rate.
• Convert a variable interest rate to a fixed rate.
• Reduce total interest costs.
• Pay off the mortgage sooner by shortening the repayment term.
• Lower the monthly payment by extending the repayment term.
• Withdraw equity as cash to fund repairs, improvements, purchase additional properties or other purposes.

How refinancing a rental property differs from other refinancing

When you want to refinance any property — your home, vacation home, investment property — you’ll need to have some equity in it. Typically, to refinance a mortgage on your primary residence, you’ll need to have at least 20% equity in your home, meaning your mortgage balance is no more than 80% of the appraised value of the house. For an investment property, lenders generally prefer borrowers to have at least 25% equity in the property.

Interest rates for refinances are typically higher than purchase interest rates, and this is true for investment properties as well. What’s more, you may find interest rates for refinancing an investment property are also higher than interest rates for refinancing a primary residence.

6 steps to refinance an investment property

Many aspects of refinancing an investment property are the same as refinancing your primary residence. Here are the six steps to follow to refinance an investment property.

Step 1: Make sure you qualify for refinancing

Lenders usually have stricter requirements for refinancing investment properties than primary properties. This is because if someone struggles financially, they may be more likely to default on their investment property than the home they live in.

In most cases, lenders will want to see a maximum loan-to-value ratio, or LTV, of 75% and more than 25% in equity. Your LTV is the amount of your mortgage versus the appraised value of your property. If your LTV is too high, you may want to make a larger down payment or choose a less expensive investment property.

Step 2: Gather the documents you’ll need

To refinance an investment property, you’ll need more documentation than you would if you were to refinance a primary residence. Most lenders will ask you for the following:

• Recent pay stubs or W-2 forms
• Personal and business tax returns from the past two years
• Bank statements from checking, savings and business accounts
• An IRS Schedule E: Supplemental Income and Loss form that shows your rental income
• Copies of current rental lease agreements
• Proof of homeowners insurance

Keep in mind that if you’re an entrepreneur or self-employed, you may need to provide other documents. The same holds true if you’re retired and earning Social Security income.

Step 3: Compare lenders and refinance rates

Not all mortgage lenders will refinance an investment property loan. And rates, terms and qualifying requirements can vary widely among those that do offer investment property refinancing. Comparison shopping for a refinance lender can help ensure you find the best interest rate and terms for your needs.

Step 4: Apply to refinance your investment property

Once you choose the best lender for your unique situation, you’ll need to agree to a credit check and complete its full application online or in person. Keep all your documents handy so you can easily fill out information about your income and debts. If you’re applying with a co-borrower, you may want to fill out the application together, as you may need to ask them questions about their employment or income.

Step 5: Lock in your mortgage rate

After you’ve applied for your loan, it’s in your best interest to lock in your mortgage rate. A mortgage lock guarantees your quoted rate for a certain period of time, usually between 30 and 60 days. Mortgage rates fluctuate on a daily basis, so this strategy can protect you from rate increases. If there’s a delay in your loan process for any reason, you may be able to extend your lock.

Step 6: Close

The last step of refinancing your investment property is closing. This is where you’ll finalize all the details of your transaction. You’ll need to go to your closing appointment with your closing agent and sign some legal documents. You may also need to pay your closing costs, which will likely average around 2% to 5% of the sale price.

Unless you change your mind within three days, the lender will refinance your loan and you’ll be good to go. Once you’ve officially closed, be sure to store all your documents in a safe place.

To make sure your closing goes as smoothly as possible, keep in touch with your lender for several days beforehand so you know exactly what documents you’ll need at the closing table.

Pros and cons of refinancing an investment property

Any financial decision you make has potential advantages and disadvantages. It’s important to weigh the pros and cons carefully when deciding if refinancing your investment property is the right move for you.

Pros of an investment property refinance

• Reduce your interest rate — If market rates have dropped below your current loan’s rate or your credit has improved, you may be eligible for a lower rate. A lower rate can lead to smaller monthly payments and save you thousands of dollars over the life of your loan.
• Change your loan term — You can refinance into a shorter-term loan and pay off your mortgage faster.
• Increase your rental property income — Since refinancing your rental property can lower your rate and monthly payment, it may boost your monthly profits after you reach the break-even point for closing costs.
• Fund repairs or improvements — If you tap your property’s equity when you refinance, you can use the cash to pay for repairs or upgrades to the property, which in turn could increase the property value and allow you to charge more rent.

Cons of an investment property refinance

• Potentially higher interest costs — Just as interest rates tend to be higher for mortgage refinances on primary homes, investment property refinance rates tend to be higher.
• Closing costs — As with any real estate loan, you’ll need to pay closing costs with an investment property refinance.
• Tougher qualifications — You may need a higher credit score and lower debt-to-income ratio to qualify for an investment property refinance.
• Higher returns aren’t guaranteed — If you refinance to fund property improvements, there’s no guarantee they’ll pay for themselves down the road. If, for example, property values decrease in the area, you could find yourself upside down on your refinance loan.

Can you use a cash-out refinance on a rental property?

You can use a cash-out refinance on a rental property. If you go this route, you’ll take out a new loan for more than you currently owe and pay off your existing mortgage. Then, you’ll get to pocket the difference as cash. You can use the money to improve your property, buy new properties, pay off debt or virtually anything else.

If you decide to move forward with a cash-out refinance, note that you’ll likely need good credit and more than 25% in equity. Also, interest rates may be a bit higher than they would be if you chose a traditional refinance.