Refinancing, when done strategically, can be a very useful tool. Paying off an existing mortgage and replacing it with a new one at a lower interest rate or a shorter term can greatly improve the profitability of an investment property. Another potential benefit of refinancing is the possibility of converting an adjustable-rate mortgage to a fixed one with a lower monthly payment. You can also use refinancing to tap into the equity you’ve accumulated to make improvements, or another investment.
Before you do however, it’s important to recognize that refinancing a rental property will be costlier than refinancing your principal residence because financial institutions consider lending for income properties more of a risk than writing loans on primary dwellings. The assumption is you’ll need the rental income from the property to service the loan and vacancies can occur from time to time. To cover themselves in the event of a default, lenders usually factor in an added margin of income by bumping the interest rate by as much as .5 of a percent. Even with this consideration, refinancing a loan can still improve your financial position in a property.
With all that said, here’s when you should consider refinancing your home.
Interest rates are down
Given the extra .5 percent a lender is likely to charge when you refinance a rental property, if you can save 1.5 to two percent in interest, a refinance is worth pursuing. Reducing the interest rate means you’ll pay the loan down quicker and potentially reduce your monthly debt service payments. This will give you more liquid capital to invest elsewhere, or make improvements on the refinanced property to increase its value.
Shorten a loan term
You can also use refinancing to shorten the loan term. This will enable you to satisfy the debt sooner without having to increase your monthly expenditures. Once the loan is paid off, those former loan payments can be put to good use elsewhere.
Economically convert an adjustable to a fixed
The monthly payment on an adjustable mortgage fluctuates with the ebbs and flows of the financial market or instrument to which its interest rate is tied. When rates rise, you’ll pay more each month. When rates fall you’ll pay less.
Those rises can eventually result in you paying more overall than you would with a fixed rate.
On the other hand, an adjustable-rate mortgage can make it easier for you to acquire a property, if you’re looking at it as a long-term investment. Then, when interest rates drop, you can refinance the loan and convert it to a fixed mortgage with lower costs in the long run.
Tap into equity and/or consolidate debt
Refinancing to tap into equity or consolidate debt is a viable strategy. However, refinancing a property repeatedly can result in the accumulation of infinite debt. Also, if you’re tapping into equity to make another investment, be sure the rate of return on that investment will ultimately be greater than the interest you’ll pay to secure the refinancing in the first place. Along those same lines, if you’re refinancing to consolidate debt, be certain the numbers pencil out, then make sure you don’t turn around and create more debt because your reduced debt-to-income ratio means you can qualify for another loan.
Managed properly, refinancing can be a very powerful tool. You can use it to increase the size of your investment portfolio considerably with the resulting lower interest rates, shorter loan terms and additional liquid capital. However, you must be careful to improve your financial position rather than detract from it. The smart play always angles toward reducing debt, building equity, freeing up cash and eliminating mortgages.
Refinancing can help you accomplish all of those goals—as long as you do it wisely. Always figure out exactly how much money you stand to save by taking on the new mortgage when you’re considering a refinance. Bear in mind it typically costs between three and six percent of the loan principal to execute a refinance. You’ll also pay a slightly higher interest rate when you refinance an investment property. Make sure you factor in all of the associated costs to get an accurate accounting of your potential savings before you make your final decision.
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