Can I Cash Out Refinance a Rental Property?
The term “cash out refinance” is one that real estate investors use all the time, but let me really take a moment to clarify it. A cash out refinancing, as the name implies, entails obtaining some cash as payment for the loan.
Rate and term refinances apply to the majority of refinances. This indicates that the interest rate (the rate) and the loan’s duration (the term) are the only two variables that differ between the two loans. Assume, for instance, that the balance of your 30-year, 4.25% mortgage on your principal home is $200,000. You’ve paid down a sizable amount of the initial loan debt because you’ve owned the house for 10 years.
It would be a rate and term refinance if you were to refinance the $200,000 remaining on your loan into a new loan with a 15-year term and 2.25% interest. All you’ve done is switch the period from 20 years left on a 30-year loan to 15 years, and you’ve altered the rate from 4.25% to 2.25%.
Conversely, suppose your house is now valued at $450,000 on the market. You would own $250,000 in equity in the home with a $200,000 mortgage balance ($450,000 valuation less $200,000 loan balance). One possible way to obtain part of that equity would be to refinance for cash out. Up to 80% of the loan-to-value (LTV) can be refinanced with cash out by most lenders.
Accordingly, you might be eligible for a refinancing loan in this case up to $360,000 ($450,000 worth times 80%). However, since you now owe money on your mortgage, the first $200,000 of your new loan would be used to settle that debt, leaving you with $160,000 in cash (not including transaction expenses).
Additionally, since the cash out refinancing funds are your money, there are no restrictions on what you may do with them. You are free to spend it all on a vacation to Las Vegas, but I strongly discourage making such a huge commitment. Real estate investors more often use their cash out refinancing profits as startup money for new projects.
Refinancing for Cash Out Using a Rental Property
Can a rental property be refinanced for cash out, though? You really can, yes! But investors also need to be aware of a few other factors. Above all, keep in mind that not every lender will provide this kind of refinancing. As a result, it’s helpful to know how lenders see various refinance scenarios, such as rate and term or cash out, while looking for one.
I’ll go over three possible rental property refinancing scenarios. Assume that the investor has 20 years left on a 30-year mortgage and a $100,000 amount for each.
First Scenario: Refinancing Rate and Term
The investor in the first scenario does not require any cash in order to reduce the interest rate. Consequently, he lowers his interest rate by 2% by refinancing the existing mortgage into a new $100,000, 15-year mortgage. Since the only things that changed in this situation were the interest rate and loan duration—not the investor’s cash—it is obvious that this is a rate and term refinancing.
Second scenario: Cash Out refinancing
Let’s say that the same investor wishes to use the equity already present in the property to get the $20,000 he needs to fix a roof. He also chooses to refinance, but since he is taking out a $20,000 cash advance over the previous mortgage total throughout the process, his new loan balance will be $120,000.
Situation 3: Continued Cash Out Refinancing
I want to draw attention to this last possibility since it causes confusion for certain investors. Assume that the investor required an additional $20,000 for roof repairs. But he uses a credit card to pay for it instead of waiting to finish a cash out refinancing. After that, he intends to refinance his existing mortgage into a larger one and use the money left over after the roof repairs to pay off the $20,000 credit card debt.
This is still seen by lenders as a cash-out refinancing. Lenders consider you to have gotten cash from the refinancing even if you take the funds and utilize them right away to pay off a credit card or other debt. I stress this because it’s not always easy to locate.
Important Obstacles to Cash Out Refinances of Rental Properties
When submitting an application for a cash-out refinancing on a rental property, investors must be aware of four related obstacles. These things don’t imply that you can’t or shouldn’t finish a cash-out refinancing. Instead, armed with this knowledge, you’ll be more equipped to carry out the procedure if you determine it makes sense.
First Challenge: Tighter Inspection of Home Value
Lenders have relaxed evaluation criteria in recent years. And in the COVID-19 age, this loosening has quickened. Lenders no longer always required complete appraisals that involved the professional appraiser accessing the property; instead, many now permit “drive-by appraisals,” which do not involve property entrance.
First off, these assessments are now more trustworthy due to the abundance of internet property data. Second, many lenders are attempting to avoid having to bring strangers into a borrower’s house because to COVID-19 issues.
However, the conditions for cash out refinancing evaluations for rental properties have not been loosened. Banks will examine the home’s worth more thoroughly before authorizing a final loan amount since they often see these loans as riskier than rate and term refinances. Because of this, you can expect a thorough appraisal—no quick, “drive by” ones—during the cash out refinance procedure.
Problem 2: Increasing Interest Rates
Lenders usually demand the highest interest rates for cash out refinances of rental properties because of the associated risk. Refinancing a primary house yields the lowest rates.
These higher rates may result in noticeably larger monthly payouts for investors. Additionally, investors have to weigh the possible returns from investing the cash out refinancing proceeds against these increased payments. Consider a scenario where an investor must choose between a $250,000 rate and term refinance and a $275,000 cash out refinance with 15-year terms. There is often a half percentage point gap between these two loan products, however spreads do fluctuate.
Assume, for the purposes of illustration, that the investor is eligible for a rate and term refinancing at 3.75% and a cash out rate at 4.25%. For a 15-year loan with these loan amounts and terms, the investor would have to pay an extra little over $250 per month for the cash out refinancing.
