When Should I Refinance My Rental Property?
One of the most exciting times in the life cycle of a real estate investment is when it’s time to refinance. Your wealth has been tied up in equity … but at refi time you get to turn that equity into cash! Best of all, a refi is a not-taxable event — no capital gains taxes to pay to Uncle Sam. In this article we help you answer the question: “Is it the right time to Refinance My Rental Property?”
That being said, there’s a right time and a wrong time to refinance. Here are some circumstances when it may make sense to refinance your rental property …
1. When You Paid All Cash
If you paid all-cash because you couldn’t get a loan or didn’t like the lending environment, you might want to refinance to add leverage to your investment and pull out principal for other investments. This isn’t “refinancing” since you didn’t finance in the first place, but on paper it’s a “cash-out refi.”
2. When You Can Get A Lower Interest Rate
As I’m sure you know, interest rates are higher now than they have been in the past ten years. The Fed is making big moves. If interest rates come down in a few years, it might be worth refinancing into that lower interest rate to get a lower payment. But be careful — read #6!
3. When You Can Pull Out The Principal
If you have built substantial equity in the property — either through appreciation or principal paydown — it may be time to pull out the principal. For example, if you put $50,000 into acquiring the property and your refi will net you $50,000 cash, you have pulled out all of the principal. If your refi will net $25,000 cash, you have pulled out half of the principal.
Why do this? Because it de-risks the investment. There’s no more risk of losing all your money … because you have all your money back. But you still own the asset! You still get to collect cash flow and enjoy future appreciation.
But refinancing to a bigger loan adds risk in a different sense, as we’ll see in #4 …
4. When Your Cash Flow Increases
A cash-out refi usually means replacing a mortgage loan with a bigger mortgage loan. After all, you have to pay off the first loan. Unless you got a much better interest rate in #2, that also means a higher mortgage payment.
A bigger mortgage payment eats into your cash flow. Smaller cash flow means a greater risk that you can’t pay the bills, which can have drastic consequences – up to and including foreclosure.
In other words, you don’t just want to refi when you have more equity — you also want more cash flow. Focus on increasing revenue and lowering operating expenses today to set up your refi for the future.
5. When You Can Get Higher Loan-To-Value
The bigger the loan-to-value (LTV), the more leverage you have. Sometimes you may only be able to get 75% LTV, but you find a refi of 80% LTV or more. At this point, you can probably pull out a substantial amount of cash by refinancing … but watch out for that cash flow (#4) and those fees (#6).
6. When You Can Avoid Heavy Fees
Okay, this is a big one. Your cash-out refi won’t be pure cash-out. You will probably owe application fees, appraisal fees, and possible loan points, which will eat into your cash-out.
Additionally, if your loan has prepayment penalties, you might want to wait until those penalties expire — even if you enjoyed a big increase in equity. Excessive fees are just a gift you’re giving to your lender. Yes, they’re doing you a service … but that should be your money!
7. When You Need To Finance Construction
If your asset is in need of serious repairs — new roof, HVAC, foundation, etc. — a refi might provide the cash to do it. You might also consider a refi for products that add value to your asset, like an addition, extra bathroom, or ADU.
8. When You Had Short-Term Debt
If you bought the property with short-term debt — a hard-money loan, construction loan, or bridge loan — the ultimate goal is to refinance into long-term debt. Otherwise, you will owe a balloon payment in the form of the entire remaining balance.
Think of the above points as stars that have to align. When the stars align, the time is right to refinance. In our experience, the time is usually right at about the five-year mark.
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