The Landlord’s Guide to Cash-Out Refinance

A cash-out refinance is one way for investors to tap into equity and recent appreciation in order to scale their portfolio and build wealth. With demand for real estate strong today, and home prices up in many places across the country there are a lot of investors exploring cash-out refinancing options for just this reason.

However, everyone’s situation is different, what might suit some people’s long-term financial goals might not be right for others. In this article, we take a look at the what, why, and how investors might opt for a cash-out refinance as well as the pros and cons.

What is a Cash-Out Refinance for Rental Property?

A cash-out refinance is essentially the same thing as refinancing a primary residence. You take out a new loan for your current property value, pay off the existing loan balance, and keep the difference in cash.

Generally, this strategy is used to extract equity from an existing asset. For example, if you had a rental property that you’ve been paying the mortgage on for 10 years then you would have 10 years’ worth of equity plus your original deposit. Once you have taken the equity out as cash you can use it to improve the property, grow your portfolio, or for other uses as we explore below.

5 Things to Know Before Committing to a Cash-Out Refinance

Before diving straight in, it's a good idea to explore exactly how a cash-out refinance works and consider if it’s really the right choice for you. We take a look at five key considerations.

1. The cost associated with the loan

Taking out a new loan comes with a variety of costs and fees from the closing costs to the appraisal and potentially property taxes along the way. These costs can vary widely from situation to situation but are important to take into account, especially if you don’t have a lot of equity in a property

2. Interest rates and fees.

Along the same lines as the previous point, taking out a new loan can actually end up costing you more in the long run. Banks tend to view investment property loans as riskier than owner-occupied homes. As such, interest rates are often higher to compensate. It’s important to run the numbers to make sure the equity you can get out makes sense, as you may get a worse interest rate and have to pay additional loan fees.

3. Maximum loan to value ratio (LTV)

Lenders typically allow a maximum loan to value ratio of 75%. This means, that in most scenarios you will need to have more than 25% equity in your rental property to do a cash-out refinance.

4. What are your financial goals?

Depending on your long-term financial goals, a cash-out refinance may not be the most suitable option for you. However, there are some common ways that people will use cash-out refinances.

• renovating to increase the value of the property
• renovating to increase the value of a different property
• to purchase another investment property
• to finance a real estate project such as a flip

5. Lender requirements and financing rules

There are some basic rules that you need to know regarding cash-out refinance, including:

• The minimum credit score set by lenders is generally between 680 and 700.
• Cash reserves. Lenders will want you to have up to 12 months’ worth of mortgage payments in cash.
• LTV ratio. Lenders will want you to have at least 25% equity in the rental property.
• Lenders may require a waiting period of six months from the time of purchase before an investor can refinance around to property.

3 Reasons Investors Choose to do a Cash-Out Refinance

Generally, investors choose to do a cash-out refinance in order to get access to cash that would otherwise stay locked away. There are plenty of reasons investors might want access to this cash from personal ones to pursuing new investment opportunities. Here are three main reasons an investor might consider a cash-out refinance.

1. Home Improvements. While property improvements can be expensive they can also be worth it, increasing the value of the asset and for rentals allowing you to charge more in rent to improve overall cash flow.
2. Expanding your real estate portfolio. By leveraging the equity that you hold in existing assets, you may be able to put deposits down on new properties and expand your portfolio faster.
3. To take care of other large expenses. The third major reason that an investor might opt for a cash-out refinance is because of a large and unexpected expense. This could be education costs, medical debt, or even damage to the property that isn’t covered by insurance. Doing a cash-out refinance may be a smarter way to get funds at a lower interest rate than a personal loan.

How to do a Cash-Out Refinance on a Rental Property

Below we outline the general steps to follow when refinancing a rental property.

1. Gather and collate all required documentation.

This includes:

• Proof of income such as pay stubs or bank statements.
• Copies of W2, 1099 forms, or recent tax returns to verify income and employment history.
• Evidence of homeowners insurance and rental property coverage.
• Copy of most recent title insurance received when you purchase property.
• Additional asset and debt information such as personal and business banks and savings accounts, retirement and brokerage accounts, and existing debt and monthly payments.

2. Apply for a property cash-out refinance.

It’s a good idea before doing this, to shop around for rental property refinancing options some lenders will offer better rates and some will be more willing to work with you to ensure that you get a loan that works for you.

3. Lock in the interest rate.

Once you’ve completed your application for a cash-out refinance on your rental property and it’s been approved the lender will often give you the option to lock in your interest rates. Generally, these interest rate locks vary between 15 and 60 days and it allows you time to review the cash-out refinancing terms without having to worry about changes to the interest rates.

4. Proceed with underwriting.

The process for underwriting a loan will require the underwriter to verify your income employment history and assets. Part of this process will also mean ordering an appraisal of the property to determine its current fair market value and inspect the overall condition of the property.

If you’re using Landlord Studio to track the financial performance of your rental properties, you can generate informative income statements, rent ledger, and other financial reports that can help your appraiser come to terms with the current financial performance of your portfolio.

5. Close on the rental property refinancing loan

The final step is to close on the loan. You will be provided by your lender with a closing disclosure that provides details about your cash-out refinance rental property loan including things like the closing costs and fees. You will have an opportunity to review all of these loan documents. Ask any final questions and verify that all loan charges and interest rates are correct. Once it’s closed, you’ll receive the money.

Types of cash-out refinancing for rental property.

When refinancing rental property, you’ll generally need to have more than 25% equity in order to pull cash-out and meet the maximum LTV requirements set by Fannie and Freddie:

Fannie Mae

Find out more about Fannie Mae cash-out refinance loans requirements.

Freddie Mac

Find out more about Freddie Mac cash-out refinance loans requirements.

Pros and Cons of a Cash-Out Refinance on Rental Property

Benefits of a cash-out refinance

Building equity through an appreciating asset such as property is a great way to build long-term wealth. Additionally, it comes with recurring income, positive cash flow and numerous tax advantages.

Doing a cash-out refinance allows you to take some of that equity and appreciation and expand your rental operation and business. Having this equity turned to cash can be used for several reasons such as:

• Raising investment capital
• Updating existing properties
• Paying off other real estate loans or high-interest personal debt

The main benefits of a cash-out refinance are the ability to consolidate wealth and expand your portfolio.

Drawbacks of a cash-out refinance

Whilst these benefits all sound great, there are some drawbacks as well that need to be considered before a cash-out refinance is undertaken.

First of all, a lower interest rate isn’t always guaranteed if you had a particularly good interest rate on your loan to begin with a cash-out refinance might actually increase your overall interest and negatively affect your long-term cash flow. Secondly, it’s important to take into account all the fees and costs associated with the process from the appraisal to any loan fees.

Ultimately, if the process doesn’t release a substantial amount of equity. And if the returns you’re going to get from the equity aren’t good enough, you could end up actually losing money and setting yourself back years. Simply put, if there isn’t enough potential profit, it may make no sense at all to refinance your current loan.

Final Words

For many investors, the cash-out refinance process is worth the extra effort. Having cash to hand by pulling it out of one or more of your properties is a tried and tested method for expanding your portfolio. You can use your equity as a downpayment for your next rental and it means you’re going to be ready to snap up at that great deal when it comes along.

However, it’s not always the right decision. And so, as always, it is a good idea to talk with your financial advisor or CPA to make sure that the numbers add up, and that this is the most effective use of your equity and a suitable course of action for you and your situation to reach your long term financial goals.