Know the Pros and Cons Before You Make A Decision on Refinancing Your Mortgage
Everywhere you turn, there seem to be new options for what to do with your home equity. And of all the possibilities facing someone with equity, none are as exciting as the potential of investing in a second property.
But let’s not get ahead of ourselves. If you’re fairly new to homeownership, you might be asking,
“what even is home equity?” Essentially, home equity is the difference between what your home is worth in today’s market and what you owe against that home. In effect, equity is what you “truly” own in your property. Banks and lenders will allow you to borrow money against this portion you own, so you can use that money to invest elsewhere. For example, you could use the extra money to buy another property.
This is where refinancing comes in.
What is Refinancing?
Refinancing is basically the process of getting a new mortgage by renegotiating and technically paying off the mortgage you already have on your home, with a new one created in its place. There are a few reasons why people look into refinancing - paying off debt, remodeling, taking advantage of lower rates, and switching mortgage providers to name a few. Whatever your reason, refinancing can be a great source of some extra capital - but there are a few things to keep in mind.
What You Need To Consider Before Refinancing
“Do a financial cost-benefit analysis to confirm refinancing makes financial sense for you and your family, particularly when buying a second property or paying off debt,” says Caroline Roach, mortgage broker, Fitzwilliam Mortgage Corp., Nanaimo, B.C. “Naturally, refinancing due to relationship and lifestyle changes is far more emotional, but as much as possible, it still has to work financially.”
Refinancing to buy a second property has its pros and cons:
Benefits of Refinancing:
- Access to equity: You can access your home equity to any value as long as you don’t exceed the 80% loan to value threshold. In layman’s terms that means the amount you owe the lender cannot represent more than 80% of your home’s value at the time of the refinance.
- Freedom to use that equity to buy an investment or recreational property: It’s your decision. You can buy an investment or a recreational property. You could even invest in the stock market, pay off debt or buy out a co-owner. “The lender will definitely ask why you’re refinancing and what you plan to do with the funds,” says Roach.
- Long-term gain and appreciation: If homeowners buy the right investment and recreational properties and keep them for five to seven years, that equity is likely appreciating. Better yet, in a rental, the tenants pay off the interest, principal and in many cases, all of the operating costs on the property you own.
Possible Refinancing Issues
Equity That’s Available Whether Or Not You Can Afford To Take Advantage Of It
As with any loan, just because the lender will give you access to more funds doesn’t mean you should take it.
- Will the family income comfortably cover the higher weekly or monthly mortgage payments on the primary home now and in a few years?
- Do you have the cash flow required for the mortgage payments, operating costs and unexpected maintenance and repairs on the second property?
- Do you have enough in your savings or other investments in case something unexpected happens and someone needs to take time off work? How would that affect your family income?
In one instance, a mortgage-free couple (0% loan to value) was at risk, because their careers were winding down and their current income left them little wiggle room once the higher mortgage on the primary residence and living expenses were paid.
Financial And Practical Challenges Presented By An Investment Or Recreational Property
Rodriguez and Roach suggest homeowners consider the worst-case scenario and assume that everything that could possibly go wrong will go wrong at some point. They also suggest buyers ask these questions before committing:
- Will the investment property’s rental income cover the mortgage payment (interest and principal), property tax, insurance, utilities, repairs, maintenance, and a property manager? If not, how much do you have to kick in every month? What will be the demand for that property or unit? Do I have the skills required to manage the investment property’s finances and the experience and time needed to deal with tenants and service providers?
“Refinancing to buy an investment property is all about the money but it goes so far beyond that,” says Roach.
- Will I be comfortable with the cost of a recreational property long term? Am I taking into consideration the time I’m actually going to be spending there? Do I have the time, energy and funds required to maintain a second, more demanding property? If I decide to sell it, has it maintained its value and how long will it take to sell?
While an investment property that carries itself should sell in a reasonable time frame in most markets, a recreational property may take over a year to sell.
“It inevitably takes more time to sell a recreational property because it’s hard to get financing on them,” says Roach. “Lenders consider isolated and rural properties higher risk due to everything from the septic systems to the lack of local fire departments.”
How Much Does Refinancing Cost?
As with most things related to mortgages, it depends. Possible factors include whether you’re breaking the mortgage term early or looking to refinance at the end of the term, and also the fees that may apply to you in case you leave your lender.
In each case, the costs you need to be aware of are:
- Mortgage Prepayment Penalty
- Mortgage Discharge Fee
- Mortgage Registration Fee
- Legal Fees with Standard Mortgage
- Legal Fees with Collateral Mortgage
Most homeowners will pay penalties of three months' interest or up to 5% of the mortgage balance as well as legal and other fees.
For example, they’ll need an appraisal to determine the home’s value when the new mortgage is being put in place. Because the Canada Mortgage and Housing Corporation no longer insures refinances, the interest rate is sure to be higher when you refinance. However, since it’s not insured, you can take your amortization to 30 years which could result in lower monthly payments despite the higher interest rate.
As Roach and Rodriguez point out, homeowners and their brokers have to do the math first to see if refinancing is cost-effective in their unique situations.
Strategize and Conquer
Now that you’re aware of the pros and cons, you know what you need to do before you refinance: hire a savvy mortgage professional, ask the right questions, crunch the numbers and be brutally honest with yourself about your finances, skills, and experience, not to mention your tolerance for risk and inconvenience.
Refinancing your current home to invest in a second property could be a great financial move if you do it right. We hope this article has you feeling better equipped to make an informed decision in case a second property fits your goals.