The following is a guest post by Betsy Fallwell. If you’re interested in doing a guest post, please see my guest posting policy and contact me.
When property prices and interest rates are low, it seems like the perfect time to look into property investment…except there’s a problem: you’re cash poor in a financial world that wants to see a lot of capital before they’ll approve you for a loan. If you’re already a homeowner who’s looking to expand into property investment, there’s a one word answer: refinance.
Option #1: Debt Consolidation Through Refinance
If you’ve got extra cash on hand but need to reduce your monthly debts to qualify for a loan, consolidating your high-interest debts into your mortgage through a refinance could be the solution. Here’s why:
- Consolidating high-interest loans – like credit card debt or vehicle loans – along with your mortgage can get you a lower interest rate, leaving you with lower monthly payments and helping you pay down your debt quicker.
- While interest incurred on credit card debt isn’t deductible on your taxes, mortgage interest is; a consolidation refinance may help your tax situation.
But there are some caveats to debt consolidation. If your loan to value ratio is more than 80%, you’ll likely have to pay private mortgage insurance, or PMI, on your loan. This can reduce some of the benefits of refinancing in the first place.
Option #2: Cash-Out Refinance
If you need cash up front to pay for a down payment – lenders usually require more money at closing to approve a loan for an investment property than for your primary residence – then a cash-out refinance may help you get there.
If you have a large amount of equity in your current home, a cash-out refinance can help you access it. This type of loan replaces your current mortgage, while paying you out a portion of the equity in your house. Say your house is worth $200,000 and you only owe $50,000; you’d like $50,000 to go toward a down payment on an investment property. Refinance $100,000 at a lower rate, plus get that $50,000 in cash you need.
But watch out – a cash-out refinance isn’t your best move if you can’t secure a lower interest rate in the process, or if taking the cash leaves you with less than 80% equity in the property; then you’ll be looking at PMI.
Option #3: Home Equity Loan
If you already have a low interest rate on your primary residence and don’t want to incur closing costs associated with a cash-out refinance to get the money you need for an investment property, there’s another option: a home equity loan.
Unlike a refinance, this is an extra loan on top of your existing mortgage. Generally, there are no closing costs with a home equity loan, although interest rates are typically higher than with a refinance. Using our example from above, let’s say you took out a home equity loan of $50,000 on your house valued at $200,000; you and your mortgage broker would find a term and rate that worked for you, then you’d get a check for $50,000. In exchange, you’d owe a monthly payment on that home equity loan, just like you would on a traditional mortgage.
Putting It All Together
You’ll need to know a few things before you start down the road to a refinance or securing a home equity loan. These factors will determine your overall borrowing power:
- Credit score – The higher your credit score (on a scale of 300 to 850), the better chance you have of securing the lowest interest rates on your loan.
- Debt-to-income ratio – This is a comparison of your debts to your gross income. One DTI ratio measures your housing debts to your income; this ratio should be no higher than 33% to secure financing. Another DTI ratio measures your overall debts to your income, and should be no more than 41%.
- Your property’s value – You have the best chance of securing a refinance or home equity loan on your existing property if the amount you owe on the property is 80% or less than the property’s value, of course the less you owe compared to this value, the more attractive a loan candidate you’ll be to lenders.
A mortgage broker can help you determine all these numbers, plus connect you with the best loan products available to you. In exchange, you won’t owe your mortgage broker anything for his services; instead, he’ll be paid a commission from the lender whose product you ultimately select.
Editor’s note: While I appreciate the author’s sentiment to not dip below the 20% PMI threshold, I would suggest treading with caution pursuing this strategy. While it might seem great at first, it has the potential to spread you too thin and take on too much risk. As with any major financial decision, make sure you do your homework to make sure the situation is a good fit for you.
Photo courtesy of: Ayla87