Cash-Out Refinance: How It Works and When to Use It
Over the last couple of years, home prices have surged despite an uptick in mortgage interest rates. As a real estate investor, rising home values can mean a significant boost in accumulated equity.
According to the latest data, home sales prices have increased every month for the first half of 2022 (Forbes). As demand for rental housing continues to remain strong, conversely recent home prices have softened. That’s why it may be tactful to tap into existing equity now by completing a cash-out refinance.
Putting your new equity to work can help accelerate the expansion of your real estate portfolio, amplify your monthly cash flow, and even improve liquidity.
However, a cash-out refinance might not be optimal in every situation. Before you commit to any new financing, it's important to understand all the potential costs and benefits it might bring.
If you have been thinking about leveraging a cash-out refinance to help grow your real estate portfolio, here’s what you should know about how the process of cash-out refinancing works.
How Does a Cash-Out Refinance Work?
What is a Cash-Out Refinance?
A cash-out refinance can be a powerful way to leverage the available equity in the real estate that you hold. It works by replacing your existing mortgage (if you have one) with a new loan that often exceeds your existing balance.
Any remaining balance over the amount needed to cover your closing costs and mortgage payoff gets paid out to you as a lump-sum cash disbursement. This even works if you own your property free and clear and the IRS does not consider these proceeds as income.
It’s important to note that creditors limit how much equity you can leverage through a cash-out refinance. For example, most lenders will only allow you to borrow between 70-80% of your rental property’s fair market value.
Also understand that when you refinance, you are taking out a new mortgage loan which means you will have different repayment terms than your existing mortgage. It also requires you to go through the mortgage application process from scratch.
How Does It Work?
While it may sound daunting having to dredge up your tax returns, bank statements, and other financial documentation, re-applying for new credit is fairly streamlined. It also offers a few hidden benefits.
For starters, if you have already applied for a mortgage in the past, you sort of already know what to expect, meaning you can have all your documents prepared and ready ahead of time.
Also, getting a new mortgage provides you the opportunity to add or remove borrowers that weren’t on the original loan. Maybe you have a partner looking to exit the rental business or are looking to add investment partners to your portfolio. A cash-out refinance could be the perfect buy-out or partnership strategy.
Lastly, refinancing allows you to select a brand-new loan term to better align with your overarching investing goals. You can either shorten the term to accelerate your mortgage payoff or lengthen the term to help keep your new mortgage payment low, thereby improving cash flow.
Deep Dive into the Math
Let’s say, you bought an investment property through Doorvest in Atlanta, Georgia - and this is the breakdown of your investment:
Purchase Price = $175,000.00
Down Payment = $35,000.00
Loan Amount = $140,000.00
Interest Rate = 6%
(Standard) Home Appreciation Rate = 5%
Home Value (after 5 years) = $223,349.27
If you were to do a cash-out refinance at Year 5, you are able to take out a loan for 75-80% of the Year 5 home value ($223,349) – leaving you with $178K.
LTV (Loan to Value) = 80%
New Loan Amount / Cash Out = $178,679.42
This doesn’t mean you can use up the entire $178K; there are other costs you need to pay back. Removing the monthly mortgage payments (i.e. your equity pay down) for 5 years, you need to pay back the remaining balance from the original loan amount:
Original Loan Amount = $140,000.00
Equity Pay Down = $9,723.91
Remaining Loan Balance = $130,276.09
Let’s do a quick recap with what we know so far: After 5 years of owning an investment property in Atlanta (with a 5% appreciation rate), you are now able to cash out 80% of the home value at Year 5 via a cash-out refinance:
5 year Home Value = $223,349.27
LTV = 80%
Cash Out = $178,679.42
So how much cash do you end up with - your walkaway - after refinancing? After you take out a 178K loan, pay back the remaining balance of the original loan (130K), and additional closing costs – you are walking away with almost $44,000.
Cash Out = $178,679.42
Remaining Loan Balance = $130,276.09
Closing Cost = $4,466.99
Net Cash = $43,936.35
You now have a new loan for $178K, which means you will have a higher monthly payment. However, the general consensus is rent will go up year-over-year so there will not be a big hit to your cash flow.
The beauty of a cash-out refinance is that with a $44K walk away, you can repeat the Doorvest process and acquire another investment property. Rinse and repeat every 5 years, and the next thing you know: your investment portfolio is geographically diversified and can hedge against any weak markets.
General Lending Requirements
Before you apply for a new cash-out refinance, it's important to understand the general qualifying criteria that most lenders have for cash-out refinances on investment properties (MortgageReports).
- Loan-to-Value (LTV)Conforming conventional guidelines requires you have at least 25% for 1-unit residential rentals and 30% if for 2-4 unit residential rentals. Some lenders may have non-QM and portfolio financing options with more liberal LTV requirements.
- Credit ScoreThe average FICO credit score in the United States has recently improved to 716 (FICO). Yet, most lenders only require a minimum FICO credit score of 620 to qualify for a cash-out refinance.In some cases, you may have to demonstrate other compensating factors (i.e., cash reserves, additional borrowers, etc.). Other lenders may have higher set minimums, although the exact score requirements can vary between lenders.
- Title RequirementsMost lenders usually require you to meet certain seasoning criteria before you can complete a cash-out refinance on rental property. Typically, you must be on title for at least six months, which is calculated from the acquisition closing date and to the date you close on your cash-out refinance. However, certain exclusions can apply in situations of inheritance, divorce/separation, or delayed financing.
- Cash Reserves
As a real estate investor, you must demonstrate sufficient liquidity and cash reserves when completing a cash-out refinance. Documenting reserves helps mitigate the enhanced risk associated with non-owner-occupied properties.Lenders will calculate the minimum reserve amount based on your proposed monthly mortgage payment along with any other real estate owned. The amount can range from nothing extra to a full 12 months of proposed payments. Additionally, you may be required to show you enough cash on hand to cover between 2-6% of any unpaid mortgage loan balances on other real estate holdings owned.
When Should You Use a Cash-Out Refinance?
With interest rates climbing and inflation hitting levels not seen in decades, you may be hesitant to put down money out-of-pocket to purchase new rental units. That’s why many investors opt to use a cash-out refinance during turbulent market conditions.
A cash-out refinance lets you leverage the equity you have already built within your portfolio so that you don’t have to put your investment strategy on hold.
For example, a cash-out refinance is beneficial when you have a rental property that is underperforming. Doing a cash-out refinance on this property and allocating the equity towards another investment will hedge the underperforming property.
Combining a cash-out refinance with Doorvest’s innovative suite of digital tools makes it easy to analyze and compare potential properties, so you never have to miss a new investment opportunity.
The funds from a cash-out refinance can be used for the down payment for acquiring new rental properties while helping you stay liquid should market conditions change.
Let’s say you do identify a property you simply can’t pass up. A cash-out refinance becomes beneficial in this case if you do not have enough capital to put down on another investment property.
If you have the means to purchase it with cash, you can also later use a cash-out refinance to recoup part of your investment by pulling part of that money back out of a property. This strategy is known as delayed financing. Most lenders allow delayed financing which is when you reimburse yourself for the cash purchase of real property up to the normal cash-out refinance limits.
While under normal circumstances seasoning requirements state you must wait six months or more, this special provision allows you to complete a cash-out refinance without having to meet the normal waiting period.
To qualify using the delayed financing rules, you must be able to demonstrate you paid for the property with cash, source the funds with bank statements, and provide a copy of the settlement statement verifying no financing was used for the purchase.
If loans were used to purchase the new property, those would need to be paid off first with the proceeds of the cash-out refinance. Some lenders may also require a title search as additional verification.
Lastly, a cash-out refinance offers you the flexibility to finance the improvement of your existing real estate portfolio so that you can charge higher rents and reduce tenant turnover. Optimizing your cash-flow potential is key, especially as real estate costs go up.
Conclusion
Real estate markets are becoming much more dynamic, but that doesn’t mean you have to put your investment strategy on hold while you wait to see how the market shifts.
A cash-out refinance can be a great way to supercharge your real estate portfolio whether you use it to finance the purchase of new properties or improve the earnings potential on your existing holdings.
While lenders have some strict requirements that investors must adhere to in order to qualify for a cash-out refinance on a rental property, Doorvest has helped thousands of investors understand and implement cash-out refinance strategies to help maximize your return on investment.