In a previous article, I discuss why it’s important to refinance your mortgage before leaving your job. No job = no recurring income = high risk = no mortgage refinance for you! You won’t even have the ability to compromise and pay a higher lower rate than if you did have a job. When you lose your W2 income, you turn invisible to the banks. Think, “You are dead to me.”
The other important refinancing situation to consider is when you are planning to turn your primary property into a rental or vacation property. You might have outgrown your existing property, but don’t want to sell given you believe real estate is a great long term wealth builder. Perhaps your company is relocating you for a better opportunity and you plan to return one day. Finally, maybe you’ve been forced to downsize and have no choice but to become an accidental landlord.
Whatever the case may be, always, always, always refinance your rental property before it becomes a rental property! If you don’t, you may miss an opportunity to save thousands of dollars in interest costs. This article will explain to you why rental property mortgages are higher than primary property mortgages by a common spread of 0.5% up to 1%.
The Difference Between Primary And Rental Mortgages By The Bank
Primary Mortgage: The primary mortgage is underwritten based on the assumption that your day job income + other alternative incomes will be around so that you can comfortably pay every month. Your W2 income viability is the ANCHOR that propels a bank to move forward and give you a new mortgage. After assessing your W2 income will the bank then account for your alternative income streams if needed.
The most important ratio your bank will look at is your debt to income ratio. They ratio they are generally looking for is roughly 33% or lower. That said, my recent loan modification required just a D/E ratio of 43% or less. Each bank is different, but the percentage is roughly around there. The number one goal for the bank is to earn a consistent spread over the life of the loan.
Rental Mortgage: Your rental property mortgage is underwritten based on the assumption of the feasibility in collecting rental income. The bank then looks at your W2 income to arrive at your total income. W2 income is preferred, however underwriters try to match income sources with the types of mortgages they are lending. The main issue is the viability of your income streams.
If you are refinancing an existing rental property, you’ve got to come up with a lease and rental history. No lease and a sketchy rental history full of missed payments will probably end your rental property mortgage refinance. Rental property mortgages often require a 30% or more downpayment compared with your typical 20% downpayment for a primary residence.
Risk Reward: It’s all about risk assessment for a bank. From the bank’s point of view, they are making a default assumption that you as the landlord require rental income to pay the mortgage. Even if you have a huge salary and lots of money saved in the bank with the existing institution, the mortgage underwriter does not put as much weight as the rental history of the property. For rental mortgages, they are essentially making a derivative bet.
Last Property Standing: In a housing downturn, the first properties to go are vacation homes followed by rental properties. A primary residence is the last mortgage a multi-property owner will default on since s/he has to live somewhere. The primary home mortgage is presumably more affordable once the multi-property homeowner gets rid of other debt. Banks know this and are more stringent in their rental mortgage lending practices. The last thing a bank wants is to repossess a property. Banks are not in the business of buying and selling properties!
THINK LIKE A BANKER WHEN YOU BORROW MONEY
Now that you understand why a bank places a higher risk on rental properties, you now know why rental property mortgage rates are often 0.5%-1.5% higher than the SAME primary property mortgage rate. Due to higher risk, banks demand a higher return on their investment in you. Banks have tighter lending standards post crisis.
Take my current San Francisco rental for example. My 5/1 ARM rate for a conforming rental loan (<$417,000) is 3.375%. Meanwhile, my 5/1 ARM jumbo primary resident mortgage is only at 2.625%. My primary home mortgage is more than double my rental property mortgage and my rental property income is more than quadruple my rental mortgage interest payments, yet the rental property mortgage is still 0.75% higher.
If my rental property mortgage was a jumbo loan, making the comparison apples to apples, then the rate would probably be closer to 3.875% (from 3.375%) vs. 2.625% for my primary mortgage. I’ve checked multiple banks, including LendingTree, and the rate spread is consistently at least 0.5% higher for rental property mortgages.
REFINANCE YOUR PROPERTY BEFORE IT BECOMES A RENTAL
When I bought my first San Francisco property in 2003, I knew it was only a stepping stone for something nicer as my income grew. I was 26 at the time and the place was a cozy two bedroom, two bathroom apartment overlooking a park in a great part of town. As it was my first and largest purchase ever at the time, I wanted to be conservative and purchased at the bottom of my range.
A couple years later, I found a house that I currently reside in and made my first property a rental. I refinanced my first residence as a primary residence, locked in the lowest rate at the time and subsequently moved out three months later and converted it into a rental. I didn’t anticipate to move out so soon after my refinance, however, when I found my new house, I just knew it was the one. I was able to make the transition work because I gave a three month rent back to the old owners of my new home. Consider the same strategy to lock in a lower rate. It’s all about flexibility and planning.
Due to refinancing my first property mortgage before moving out, I estimate to have saved over $50,000 in interest expense in the past 10 years all things being equal. That is real money that went towards savings, investments, and ultimately allowing me to no longer have to work today. When you are trying to retire early, every dollar savings counts.
REPEAT THE CYCLE AND BUILD WEALTH
There might be a point over the next five years where I will also want to rent out my current primary residence and move to a new property. I’m not sure if I’ll get a better rate than 2.625% for a five year fixed jumbo. If I plan to rent out my house, I will certainly try to at least re-lock a 2.625% rate for five years or get the best rate possible at the time. The biggest issue will be my lack of W2 income. As such, I will be working hard to build my passive income streams. Thanks to Bernanke’s quantitative easing efforts, I’m bullish that mortgage rates will stay low and rents will continue to rise.
Not only is refinancing a primary home mortgage easier than refinancing a rental property mortgage due to less documents needed (e.g. rental history, rental contract, HOA info), the rates are also much lower. The median homeownership duration of 5.6 years is too short to build real wealth. Buy, hold, refinance, and hold some more. You will be glad you did!
Recap: You should refinance your property now if you: 1) feel your job is at risk, 2) feel there is a chance you will be relocated, 3) plan to upgrade or downgrade and still keep your existing property, 4) want to save money and haven’t refinanced in the past twelve months.
RECOMMENDATIONS TO BUILD WEALTH
* Shop Around For A Mortgage: LendingTree Mortgage offers some of the lowest refinance rates today because they have a huge network of lenders to pull from. If you’re looking to buy a new home, get a HELOC, or refinance your existing mortgage, consider using LendingTree to get multiple offer comparisons in a matter of minutes. When banks compete, you win.
* Manage Your Money In One Place: Sign up for Personal Capital, the web’s #1 free wealth management tool to get a better handle on your finances. You can use Personal Capital to help monitor illegal use of your credit cards and other accounts with their tracking software. In addition to better money oversight, run your investments through their award-winning Investment Checkup tool to see exactly how much you are paying in fees. I was paying $1,700 a year in fees I had no idea I was paying.
After you link all your accounts, use their brand new Retirement Planning Calculator that pulls your real data to give you as pure an estimation of your financial future as possible using Monte Carlo simulation algorithms. I’ve been using Personal Capital since 2012 and have seen my net worth skyrocket during this time thanks to better money management.
Updated for 2017 and beyond.