Refinancing a rental can result in a lower interest rate and a better mortgage payment, which may equal more rental earnings. You can refinance with your current mortgage lender or a different company; either way, they all have stringent guidelines. Lenders know that you're more likely to stop making payments on rental property than on your primary home should you face hard times. Because of the increased risk associated with rental refinances, lenders require higher credit scores, more equity, higher interest rates and more cash reserves.
Get Your Credit in Order
The best refinance terms go to borrowers with prime credit scores, typically 720 and above. You typically need a 660 score or better to refinance a rental home, and you must have a good credit history for at least the previous year, which means no late payments. Should your lender approve your loan despite a late payment or two, it may require you to write a letter explaining the reason for your late payment. The letter helps the lender decide whether the late payment was a one-time misstep or whether you may be at risk of missing future payments.
Rentals Require More Equity
Your rental property must have sufficient equity. Equity is the difference between the home's value and the current mortgage indebtedness and any liens. If there is a tax lien or judgment lien against the rental's title, you must pay this off to refinance, which may cut into your equity. You need 25 percent to 40 percent equity to qualify for a conventional refinance. The number of rental units and your credit score affect the minimum required equity. Your lender will order a home appraisal to determine your home's value and verify sufficient equity.
Prepare to Pay More
Expect to pay a higher rate of interest on a rental refinance. To reduce your interest rate, your lender charges points. You pay points upfront at closing and they function as prepaid interest, thus reducing your long-term rate. You can either accept the higher rate, pay points for a discounted rate, or negotiate for a combination of the two. You must determine whether it makes sense to pay upfront for a lower interest rate by estimating how long you plan to keep the home and whether the value of the long-term savings outweighs the initial expense.
Show Sufficient Reserves
Lenders try to make sure that you have enough money on hand to pay the new mortgage if your tenants fail to pay the rent or you have unexpected costs. They require you to have the equivalent of about six monthly mortgage payments in an account that you can readily tap into. In addition to documentation of your six-month reserve, you may have to show the lender that your current tenants have paid rent on time for the past two years via cancelled checks or bank statements.
Weigh the Refinance Terms
Lenders generally offer two types of refinance on rental properties: cash out and no cash out. A cash out refinance yields proceeds upon closing, which you get to spent however you'd like. No cash out loans allow you to get a new loan with new terms, but a minimal amount of money back at closing, such as $500. Cash out refinances carry the most stringent guidelines, result in a higher loan balance and less favorable terms.