The 3 Major Reasons it Makes Sense to Refinance a Property
When does it make sense to pull the trigger and refinance a property? For the most part, it’s actually pretty simple. There are three major reasons to refinance a property:
- As part of a strategy
- To improve rates/terms
- To pull out equity
We’ll address each separately.
1. As Part of a Strategy
Refinancing is a key part of the BRRRR strategy. In fact, you’ll notice it’s the third R (buy, rehab, rent, refinance, repeat) in the acronym. This is our go-to strategy, and we usually get a private loan up front to pay for the purchase and rehab (or at least for most of it). But you can also purchase the property for cash and then refinance later.
Once you have rehabbed and rented the property and it has "seasoned" (the amount of time a bank requires before they will lend on the appraised value instead of your cost into the property), it's time to refinanceâeither to replace your high-interest private loan with a long-term loan or pull out the cash you put in the property to begin with.
Refinancing may also be a component of a different strategy as well. And if it's part of the strategy you are utilizing, you should obviously refinance when that strategy calls for it. Sometimes, this may be forced upon you. Say a partner demands it or the loan is nearing it's balloon and is about to be called due. Almost every loan will have a term, usually five years. Most banks will renew the loan at that time, but sometimes they will not. And national lenders that specialize in investment properties, such as A10 Capital, usually have a hard balloon date when you have to pay the loan off. In these times, unless you intend to sell, you would need to refinance.
2. To Improve Rates/Terms
The rates and terms banks offer change over time. If you have a bad loan, particularly if it's fixed at a higher rate, it's something you should definitely considering refinancing out of. My dad, for example, recently refinanced an apartment he owns that had a 5.94 percent loan on it and replaced it with one that was 4.25 percent.
The rule of thumb I’ve generally heard is that it makes sense to refinance if you can lower your rate by one full percentage point. That being said, Investopedia states that experts vary on their advice between one and two percent. The longer you plan to hold the property, the more it makes sense to accept a smaller reduction in the rate. So if you only think you’re going to hold the property for another year or two, I don’t think it’s enough to refinance for a one percent gain. On the other hand, if you plan to hold it for five plus years, in my judgement, it usually would make sense.
You can also run the numbers by hand. As The Balance explains:
“This process allows you to figure out how long it will take to recuperate the closing costs you’ll have to pay to refinance. For example, assume you’ll pay $2,000 to refinance and your payment will be reduced by $100 per month. In this scenario, you’ll start saving money after 20 months (the $2,000 expense divided by $100 of monthly savings equals 20 months).”
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Or let's put some harder numbers to it. Say you have a $200,000 loan at 5 percent interest (amortized over 30 years) costs $1,074/month. At 4 percent, it costs $955. So each month you would save $119. Let's say your expenses look like this:
- Appraisal: $450
- Recording and Title Fees: $500
- Loan Fees: $2,000
In this case, the closing costs of the loan would be $2,950. With $119 a month in savings, it would take 25 months to break even. That being said, it's not worth the time and effort to refinance a property if you're only going to break even. In the above example, I would want to plan on holding for at least four more years before pulling the trigger on a refinance.
Related: Should You Refinance Your Mortgage? Consider This.
It's also important to remember that interest rates aren't the only thing. There are many other terms to think about with a loan, including:
- Fixed rate or adjustable (it may be better to refinance an adjustable loan into a fixed one to reduce risk)
- Amortization (even at the same interest rate, a 15-year amortization will require substantially higher payments than a 30-year amortization)
- Term (as noted above, you may have to refinance to avoid a balloon payment)
- Loan fees (if too high, the fees could make even an attractive interest rate unaffordable)
3. Pulling Out Equity
One of the most important ways that real estate creates wealth is as properties appreciate and you pay down principal, your equity starts to grow exponentially. That being said, you can’t buy much with equity. To spend equity, you need to pull it out first. And so one great way to grow your real estate portfolio is to refinance properties you already own and use the equity you pull out as capital to purchase new assets with.
The question you have to ask yourself is, "Will I make a good enough return investing this money to make up for the increased mortgage payments of a higher loan?" This is something that you would need to run some numbers on. (For a how-to on that, see here.)
Another important reason to refinance out the equity in your property is debt consolidation. Mortgages are much cheaper than credit cards and many other types of debt. If you have such high-interest debts, it makes a lot more sense to pay them off with a lower interest mortgage.
That being said, I’m very much against refinancing your properties just to buy stuff or consumer goods. This type of borrowing gets a lot of people into a lot of trouble. Stuff, in the end, is just stuff. You really don’t need that much of it.
But real estate investors do need refinancing. And if you know when to use it, it can help you grow your real estate investment portfolio immensely.
Are there any other reasons you’d add to this list?