Refinancing Your Rental Property: Choosing Between Rate-and-Term and. Cash-Out Options

Most international real estate investors are unaware of one of the most powerful tools they have at their disposal.

In the United States, you can replace one mortgage with another. This process is called refinancing, which you can do for a variety of reasons. One of the most common reasons to refinance is to get a better interest rate with more favorable terms as part of a rate-and-term refinance. The other notable refinancing option is called a cash-out refinance, which allows you to pull equity out of your investment property to reallocate elsewhere.

Let’s jump into the key differences between these options to help you make an informed decision about your loan. 

Key takeaways

• Most international investors overlook refinancing, a powerful tool that can improve loan terms or unlock property equity.
  
  
• A rate-and-term refinance replaces your mortgage with one that has better terms like a lower rate or shorter loan duration.
  
  
• A cash-out refinance lets you borrow more than your current loan balance and take the difference in cash, ideal for reinvesting or covering other financial needs.

Rate-and-term refinance

Rate-and-term refinance, as the name suggests, is all about improving the terms of your mortgage. This type of refinance is primarily aimed at getting a better deal on your property loan. It allows you to adjust your loan terms, such as the interest rate and loan duration. In this type of refinancing, the loan amount matches your current mortgage balance. You're essentially replacing your old loan with a new one that has more favorable terms.

Generally, interest rates would need to be lower than you might have initially locked in for this type of refinance to make sense. While lower rates means savings on payments, there are fees associated with closing the new loan, just like the standard closing costs. These may include application fees, appraisal costs, and title insurance.

While the lower rate can save on each payment, the refinance is also an opportunity to shorten the duration of your loan, helping you pay off the mortgage faster.

Cash-out refinance

On the other hand, a cash-out refinance is all about tapping into the equity you've built in your property. Cash-out refinance allows you to take advantage of your property's increased equity by borrowing exceeds the existing mortgage balance - which was initially based on the property's original equity. This extra cash can be used for various purposes, such as property improvements, debt consolidation, or addressing other financial needs. It's a smart way to make the most of your property's value and financial opportunities.

In this case, the loan amount exceeds your current mortgage balance, and the difference is provided to you in cash. Cash-out refinances generally come with slightly higher interest rates compared to rate-and-term refinancing. This is because they carry a higher loan amount and, therefore, more risk for the lender. Similar to rate-and-term refinancing, you'll encounter standard closing costs. However, expect additional payment costs due to the higher loan amount.

The main advantage of cash-out refinance is the access to cash at closing. You can use this money for a variety of purposes, including down payment on another property.

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Important differences between rate-and-term and cash-out refinances

Here's a quick overview of the key differences between these two refinancing options:

• Purpose: Rate-and-term refinance focuses on improving loan terms, while cash-out refinance aims to access property equity.
  
  
• Usage of funds: Rate-and-term does not provide cash at closing, whereas cash-out gives you access to cash for various purposes.
  
  
• Loan amount: Rate-and-term matches your current mortgage balance, whereas cash-out lets you borrow more than your current balance.
  
  
• Interest rates: Rate-and-term usually offers lower interest rates, while cash-out typically comes with slightly higher rates.
  
  
• Fees and costs: Both options involve standard closing costs, but cash-out may have additional expenses due to the higher loan amount.

Factors affecting refinancing terms and conditions

When deciding between rate-and-term and cash-out refinance, it's essential to consider several factors that can influence your loan terms and conditions. Your credit score can impact the interest rates you qualify for. Loan-to-Value Ratio (LTV) is the ratio of your loan amount to your property's appraised value. Lenders often have LTV requirements that affect your eligibility, 70% and 80% are common, so you will need to be sure you have sufficient equity in the property to qualify. Interest rates fluctuate based on economic conditions, so it's wise to monitor market trends as you consider a refinance.

Choose the best refinance option

Choosing the right refinancing option can be a complex yet crucial decision. Rate-and-term and cash-out refinancing are two distinct options, each with its own set of benefits and purposes. Your choice should be based on your specific financial circumstances and objectives. 

Need help deciding? We can help!