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26 Feb

Should I refinance to get my rental portfolio started?


Posted by: Aneta Zimnicki

Is this you or someone you know? You are a new investor and have dreams of building a real estate portfolio. You have your primary residence and there is some locked-in equity, but gosh darn, your existing mortgage term is not expiring in the near future. That locked-in equity could be the starting point of your investment portfolio, a perfect source of downpayment on investment property. Investment property mortgages require minimum 20% downpayment (you can do secondary financing to lower that downpayment, but let’s keep it simple for this example). So, for example, if you have $50K of equity you can extract from your primary residence, you will be able to purchase a $250K property.

Before dismissing the possibility of refinancing, get the facts, do the math and evaluate the cost of lost opportunity. Breaking a mortgage entails penalties, nobody likes to pay those. It is a almost a psychological barrier, a consumer may think ‘I pay this bank so much money in interest, I can’t believe they are charging me so much to exit, haven’t they made their money already? This is robbery, I refuse to make them richer.’ The truth is, many Canadians do not complete their mortgage term. On average Canadians complete 3 years out of a typical 5 year term. Life and your plans change, it is difficult sometimes to predict if your existing financing will work for you in the future.

First off, avoid speculation and get information on the actual penalty amount and find out how they calculated it. There are different approaches how lenders do the calculations, in Canada, currently it would be the greater of 3 month’s interest or Interest Rate Differential, but be warned, the latter is still subjective (see my related post on IRD). Better yet, avoid the awkward conversation with your lender, ask your mortgage broker to contact them on your behalf, your broker will have a better understanding of the calculation details.

Then do the math. Is the penalty cost worth your while, taking into consideration the new interest rate you will be getting? One point to make here is you know what the interest rate is today, there is no way to know for sure the rate you would get when your mortgage term matures. You should be comfortable with the possibility that the rate may go up from what is being offered today. Obviously, if you have outstanding debts like credit cards, lines of credit and car loans, it always makes sense to roll them into the refinance. Each month you have these balances you are paying interest much higher than mortgage interest rate. Also, these current debts may be prohibiting you from qualifying for future mortgages, because your debt ratios are too high.

Then there is the hidden math…the cost of lost opportunity. Imagine you made your decision today to refinance and position yourself for a purchase of a rental income property. You purchased your property, start collecting rent cheques and paying your mortgage. Each month you have mortgage paydown, for example on a $250K purchase, you may be seeing approximately $300/m. Because you are a savvy investor, it is not unreasonable to see a cashflow of $100/m to $200/m (after all expenses) or much more. Also, depending where you are looking for your investment property, the market may be heating up and your choices are limited. You may want to secure that property while you can at a potentially lower price or avoid potential multiple offer situations which drive up the price. So for $250K, even at 0.5% appreciation per year that’s about $100/m. Adding the numbers up from this example, it is $500 – $600 per month or more.

There is also another bottom line that may trump all the numbers: how important is it to you to kick start your real estate investing now, start getting some real experience and credibility? Will you regret not getting in the game sooner? Is your current mortgage structure holding you back?