I get great returns on my money by investing in long-term rental properties. The more rentals I buy, the more passive income I produce, and a cash-out refinance is a great way to buy more rentals. A cash-out refinance lets you increase the mortgage of your rental property or personal residence and take cash out, which I use to buy more properties. Cash out refinances are a great way to increase returns, but they are risky if you do not have enough cash flow.
How does a cash-out refinance work on investment properties?
A cash out refinance is when the owner of a home replaces his current mortgage with a larger mortgage. The higher amount of the new mortgage, allows the owner to pay off his current mortgage and have cash left over to spend however they choose.
If the interest rate on the new mortgage is significantly lower than the current mortgage, the payments may actually be lower on the new mortgage than on the old mortgage. Most banks will allow a cash out refinance if an investor has four mortgages or less, but when you have more than four mortgages, most banks do not allow it. Most banks will not loan more than 75 percent of the home value when doing a cash out refinance for investors. My portfolio lender allows me to have a 75 percent loan to value ratio on a cash out refinance, and will also allow me to do cash out refinances when I have more than four mortgages in my name.
Can you do a cash-out refinance when you have more than four mortgages?
Most lenders go by Fannie Mae guidelines when making loans to investors. Fannie Mae guidelines do not allow a cash out refinance when an investor has four or more mortgages. Fannie Mae guidelines do allow a refinance, but you cannot take out cash; you could only pay off the current loans. Being able to refinance with more than four mortgages is why finding a portfolio lender is so important. My portfolio lender will do a cash out refinance on as many properties as I want, as long as I have enough reserves and qualify for the loan.
How I did a cash-out refinance on my third rental property
I refinanced rental property number 3 earlier this year. I owed about $72,000 on the mortgage when I did the refinance and my appraisal came in at $136,000. My portfolio lender will go up to 75 percent loan to value ratio on a cash out refinance so my new loan was $102,000. After closing costs, I was able to take about $26,000 in cash out of the property. I then used that cash to buy more rental properties with great returns.
How my cash on cash return increased with a cash-out refinance
I put about $33,500 of my own cash into rental property number 3 when I bought it. That cash generated a 28 percent cash on cash return in the first year, even with a few unexpected repairs like a new air conditioner. When I refinanced rental property number 3, my monthly cash flow went down slightly since my payment increased from $450 to $570 per month. However, my cash into the property decreased by $26,000, making my total cash into the property less than $9,000. Original cash into to property = $33,540-$26,000 (cash out) + $1,250 (maintenance) = $8,790. My new cash on cash return on rental number 3 is 92 percent, based on my new cash flow of $8,160.
Not only does my cash into the property greatly decrease, but I have more cash to buy new properties. The cash out refinance is a great technique to use on properties that require a lot of repairs, are in an appreciating market, or are purchased below market due to the equity build up.
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What are the drawbacks to a cash-out refinance?
When you refinance a home there are some negatives that must be accounted for. A refinance may cost you more money, but if you use the money from a cash out refinance or save enough on your interest rate, it still may make sense to refinance.
1. You have to pay closing costs on the new loan when you refinance. As you can see from rental property number three, I paid about $4,000 in closing costs on the refinance. I will get some of that money back because interest was included in those costs and I skipped a mortgage payment. Some of those costs are for escrow, which covers insurance and taxes, which I get a small part back as well. There is no doubt my cost basis went up on the property by refinancing because it costs money to take out a new loan.
2. When you do a cash out refinance the loan amount goes up. It will take me longer to pay off this loan because the principal went from $72,000 to $102,000. I feel I more than make up for the increased loan amount by using the money to purchase another rental property with great returns.
3. Your payment usually goes up when you do a cash-out refinance unless your new interest rate is much lower than the old rate. My cash flow goes down slightly with the refinance, but I make up for it by being able to buy another property generating much more cash flow. Overall the cash flow from both properties will be much higher than the cash flow from one property before I did the cash out refinance.
4. If interest rates keep rising it may not make sense to refinance a lower rate loan into a much higher rate loan. If rates go up more in the next year, I will have to re-evaluate the numbers to see if it still makes sense to take out money at a higher rate.
5. A cash out refinance depends on an appraisal to come in much higher than you purchased the house for, assuming you bought the house recently. The appraiser has no value to base the appraisal on as opposed to a purchase contract where the price is clearly stated. I have found appraisers tend to come in low on these appraisals, and both my appraisals came in low on my refinances. I thought rental number 3 was worth at least $155,000 and it came in at $136,000. I thought rental property number 2 was worth at least $160,000 and it’s appraisal came in at $140,000. If your appraisal comes in too low for it to make sense to refinance, your lender is probably going to charge you for the appraisal, which runs about $400-$600.
A cash out refinance is a great way to increase returns with rental properties. You must buy properties at a discount, add value through repairs or be in an appreciating market to get a significant amount of cash out. With every new property I buy, I am not only increasing cash on cash returns, but I am also increasing ROI, equity pay down, tax benefits and hopefully appreciation. Not only does a cash-out refinance increase returns, but they also allow me to buy more properties, which is even more valuable.
A word of warning, do not depend on appreciation to make money on a rental property. Appreciation is a nice bonus when doing a cash out refinance, but it in not a requirement. I base my purchases on cash flow, not possible appreciation.