Legally speaking, a bank typically prefers that you pay off an existing home equity line of credit (HELOC) before approving your loan application. This has to do with whether it is considered “superior” or in “first lien” position — that is, whether it would get paid first if you defaulted and the investment property were sold. Lenders want first lien position because it reduces the risk of loss. In many jurisdictions, superiority is determined by the date the mortgage is recorded, so if you already have a HELOC, a bank might be less willing to put your request through. In some cases, more generous financial institutions might allow you to use the loan to pay off the HELOC, and occasionally, they’ll consider willingly subordinating their lien position, or you can see if the bank that gave you your home equity line of credit will consider offering a new refinance contract.
Market Value and Equity
Equity is the difference between the market value of your home and the amount you have left to pay on your mortgage. As an example, if your property is worth $350,000 USD and it sells for that amount, if you have $50,000 left to pay, the equity is $350,000 - $50,000, or $300,000. Banks usually require larger equity on investment properties, with some looking for as much as 50%, because this indicates you have a significant ownership interest in the home. Some lending organizations, such as the United States Federal Housing Administration (FHA), provide lower equity requirements and have less stringent guidelines.
In many areas, such as the United States, tax regulations control how you must handle refinance loan interest. You may or may not be able to take a deduction on it, depending on your reason for taking on the new debt. It is advisable to consult an attorney or certified public accountant (CPA) before beginning the application process, because these laws can be quite complicated.
In most cases, it is a good idea to refinance investment property only if you plan to be at that location for at least 10 years. It generally takes at least this long before all the closing costs and other fees get recouped, which is a major reason why most lenders usually don’t offer agreements any shorter than this. Another way to consider time is to look at your monthly budget. The longer your term, the lower your monthly payments typically will be, which some people need. The tradeoff, however, usually is a higher interest rate. If you’d rather pay less in total over the life of the loan, then the best way to go often is a shorter contract, which provides a better rate of interest but which requires a higher monthly charge.
For most people, locking in a lower rate of interest is one of the main reasons to refinance. Many banks will allow you to lock in the percentage you pay, but other options are available for investors, as well. Some people, for example, like a mortgage with an adjustable rate, often because the initial payments usually are initially very low. Others look into 5/1 agreements, which have a fixed rate for the first five years and then switch to a variable one. Your financial goals and circumstances both determine which strategy is right for you when you set up your refinance contract.
When you talk with possible lenders, you might hear them talk about “points” in connection with interest. A point is the difference between the current prime interest rate and the rate the bank is going to offer to you, expressed as a percent. If it suggests “prime + three,” for example, it means your interest rate will be three points, or 3%, higher than the prime rate. Point also can refer to all the fees charged, with 1% of the loan amount being one point — a $500,000 contract with $10,000 in fees, for example, would have two points. In either case, ideally, you should keep the number of points as low as you can.
PMI and Downpayment
As you think about whether you should refinance investment property, you’ll need to consider how much you can put toward a down payment. In general, the more you can offer upfront, the less likely it is that you’ll need to buy private mortgage insurance (PMI), which protects the bank in case you default on the loan. Most banks want you to give 20% before they’ll wave this requirement.
Many lenders advise borrowers to obtain an appraisal before getting a new mortgage, because the value of the property determines how much the bank is willing to loan. By having a professional attest to what the home would sell for, you have a better idea of how much money you’ll be dealing with and, subsequently, the likely interest rate and monthly payment amount. You typically must pay up-front for the appraisal, but an added benefit of having one done is that the appraiser can explain exactly what is “good” or “bad” about the house, which lets you make plans for improvements that will bump up how much it’s worth.
Once you’re fairly sure you’re going to go ahead with a new contract, you should get all your documentation in order. In short, the lender wants evidence that you really qualify. It likely will ask for proof of income, two monthly checking-account statements, two years of W-2 forms, and a net sheet documenting investments. If you are self-employed, the bank typically will want to see tax returns from the previous two years. Getting a copy of your credit history and score is also important — the lender uses this information to get an idea of your likelihood to repay, and to figure out what interest rate to offer you. Requesting a report also can alert you to any irregularities such as delinquencies and collections that you can remedy for a better contract.
Not all banks are created equal when it comes to the terms and conditions of their mortgages. Shopping around is the only way to see where the best deal is, and in some cases, knowing what another lender can offer allows you to negotiate for something better. Although time can be of the essence in terms of getting the loan money, it’s generally better to spend a few days or weeks considering all your options than it is to lock yourself into an agreement you end up hating.