Cash out refinance to buy investment property: The investor’s guide
If you own rental property and need money to cover a large bill or extend your portfolio, a cash-out refinance may be the way to go. Using the equity in your home to obtain quick cash appears to be a good idea on the surface, but you must ensure that it fits into your overall financial strategy. It’s critical that you understand your entire and specific financial objectives and determine whether a cash-out refinance would hamper or assist you in achieving them.
A cash-out refinance is when you receive a new home loan for more money than you owe on your current home. The difference between your new mortgage amount and your previous mortgage balance is paid to you in cash at closing, which you can use for home upgrades, debt consolidation, or other financial needs. However, because you’ll be repaying a larger loan with different conditions, you should assess the benefits and drawbacks before going ahead with a cash-out refi.
This article will walk you through the ins and outs of a cash-out refinance so you can decide whether it’s right for you.
What Is a Cash-Out Refinance?
A cash-out refinance is when you replace your current mortgage with a larger loan and receive the difference in cash. Two important things to remember:
- The amount you can borrow is based on the amount of equity you have in your home.
- You typically can’t borrow all of your home’s equity.
In the real estate industry, refinancing is a common process for replacing an existing mortgage with a new one that often offers the borrower more advantageous terms.
A cash-out refinance is one method for homeowners to obtain a lump sum of money. The procedure entails taking out a new mortgage that is larger than the previous mortgage. The difference is then paid to the borrower in cash.
A cash-out refi is only viable if the borrower has enough equity in their home. Cash-out refinances are typically limited to 80 percent of the equity a borrower has built in their home. Keep in mind that this may vary based on a lender’s policies.
Lenders calculate your home equity by subtracting your loan balance from your home’s appraised value. They also limit how much you can cash out by setting loan-to-value (LTV) ratio requirements. Most lenders set an 80% LTV limit, meaning you can borrow up to 80% of your home’s value.
What Is Cash-Out Refinancing Used For?
The primary motivation for homeowners to pursue cash-out refinancing is to convert some of their built-up equity into cash.
Before we go into how to acquire a refinance for an investment property, it’s critical to know what a cash-out refinance is and how it functions. This procedure, like every refinance, includes replacing your present mortgage on the property with a new one with good deals.
On the other hand, a rate-and-term refinancing allows you to lend more than you have on the property and get the shortfall in cash, whereas a cash-out refinance means borrowing more than you have on the property and obtaining the difference in cash.
To give an example, if an investor owes $150,000 on an investment loan and refinances it for $200,000, they will get $50,000 in cash.
How Does a Cash-Out Refinance Work?
The borrower locates a lender who is willing to partner with them. The previous loan terms, the balance due to pay off the previous loan, and the borrower’s credit rating are all considered by the lender. An underwriting analysis is used by the lender to make an offer. Afterwards, the borrower receives a new loan that pays off the old one and binds them to a new monthly payment schedule in the future.
For the most part, a cash-out refinance works like any other home loan. You shop for a mortgage lender, fill out a loan application and qualify based on your credit, income and assets. However, there are a few extra considerations:
- You must qualify for a higher loan amount. Because you’re taking out a new loan for more than you currently owe, your lender will need to verify your ability to afford a larger loan amount and higher monthly payment.
- You’ll pay for a home appraisal. Until a refinance home appraisal is completed, your cash-out refi loan amount is just an estimate. If your appraisal comes back lower than expected, you may not qualify to borrow as much home equity as you’d hoped.
- Your lender finalizes your cash-out refinance loan amount. Once your appraisal comes back, the lender calculates your cash-out amount by subtracting your current loan balance from the final loan amount.
- Your old loan is paid off and you receive the rest of the money in cash. Once you review your closing disclosure to confirm the final figures and sign your closing papers, your lender will fund your loan. Your old mortgage is paid off, the new mortgage is secured by your home and a wire or check is sent to you.
How to Do Cash Out Refinance to Purchase Investment Property
The following are the basic steps to take when refinancing a rental property to take out a loan:
Collect the Papers That the Lender Requires
- If you’re self-employed, you’ll need proof of income, such as pay stubs or bank records.
- Bring copies of W-2, 1099 forms, or the latest tax returns to prove income and job history.
- Proof of homeowner’s insurance and coverage for rental properties.
- Copy of the most current title insurance policy you got when you bought the house.
- Extra asset and debt data, including personal and commercial banking and savings accounts, pension and brokerage accounts, as well as existing debt and monthly bills.
Register for a Cash-Out Refinance of Your Rental Property
Although lenders can establish their own regulations for refinancing rental properties, most stick to Fannie Mae and Freddie Mac’s guidelines.
Based on your banking institution and the present success of your rental property, some lenders may be prepared to work with you on the interests rate and loan fees.
Lock Down the Interest Rate
When your cash-out refinance request for your rental property is accepted, the lender will usually offer a choice of locking in your interest rate.
Interest rate locks can last anywhere from 15 to 60 days, depending on the property and loan kind. Locking the interest rate gives you time to analyze the cash-out refinancing arrangements without worrying about changing interest rates.
Investors that expect interest rates to fall may prefer to let the rate float rather than lock it in. Locking in an interest rate, on the other hand, gives security in the case the interest rates start to rise.
Continue With Underwriting
The procedure of underwriting a loan is quite basically a process of screening a potential tenant. The underwriter will check your revenue, work history, and assets once all of your documentation has been submitted.
Getting an appraisal to assess the fair market value of an investment property and examining its condition are both part of the underwriting procedure for a cash out refinance to buy investment property.
Additional financial information, such as the income the property generates and any changes and modifications you’ve made in recent years, might enable the appraiser to comprehend the true worth of your rental property fully.
Settle On the Refinance Loan
Once your refinance loan has been properly approved and underwritten, the final stage is to close on your loan.
Your lender will send you a Closing Disclosure a few days before the deal closes, detailing the terms of your cash-out refinance rental property loan, including closing expenses and fees.
You’ll get the chance to go over all of the loan documentation with your lender, pose questions, and double-check that the loan fees and interest rate are accurate at closing. You’ll get the money from your cash-out refinance between one or two working days after the deal closes.
Benefits of Cash Out Refinancing
- Potentially lower rates: If you bought your property while rates were higher, you’ll get a lower interest rate. This is not always the case.
- Consolidating debt: A cash out refinance might be used to consolidate debt that has become unmanageable. A cash out refinance might help you get out of a difficult spot, whether it’s a slew of maxed-out credit cards or a high-interest payday loan you took out without thinking.
- Credit score boost: Paying off your credit cards in full with a cash-out refinance can help you improve your credit score by lowering your credit utilization ratio. Lowering your credit utilization ratio is always a plus for credit agencies, and it could lead to even reduced borrowing rates in the future.
- Access to more funds: Cash-out refinances are advantageous for major expenses such as home renovations or college tuition because you may generally borrow far more than you could with a personal loan or by using credit cards.
- Tax Implications: If you use your mortgage for capital home improvements, your interest may be tax deductible. For further information specific to your circumstances, we advise you speak with a tax professional.
Cash-Out Refinancing Eligibility
To determine eligibility for a cash-out refinance, lenders look at various factors in addition to home equity. Here are some examples of what a lender could consider:
- Home equity: To qualify for a cash-out refinance, you’ll generally need at least 20% equity in your home. To put it another way, you’ll need to have paid off at least 20% of the house’s current appraised worth.
- Credit score: Borrowers with a higher credit score may be able to get a more competitive interest rate on their cash-out refinance.
- Debt-to-income ratio: The amount of your monthly debts and payments divided by your entire monthly income is your debt-to-income (DTI) ratio.
- Appraisal value: A property valuation, usually a recent appraisal, is required for some refinances. However, some lenders may find an alternative to a comprehensive evaluation, such as a virtual value, so double-check the lender’s requirements.
- Seasoning: Seasoning has to do with how old a mortgage is. Usually, lenders consider a mortgage “seasoned” if it has been in place for at least 12 months. If a mortgage is not considered properly seasoned, a cash-out refi may not be possible.
After you submit an application for a cash-out refinance, your lender will decide whether or not to approve the refinance. To prove your DTI ratio, your lender may request financial documents like bank statements, W-2 or pay stubs. Your lender will then assist you through the next steps toward closing when you receive approval.
Maximum 80% LTV ratio
A maximum 80% LTV ratio is the standard for both FHA and conventional mortgages. However, there is one major exception: Eligible military homeowners can typically borrow up to 90% of their home’s value with a VA cash-out refinance.
Minimum 640 credit score
Conventional cash-out refinance guidelines require a 640 score. Meanwhile, the VA doesn’t set a minimum score, but many lenders also set their own at 620. FHA loans are the exception, and borrowers may qualify with scores as low as 500.
Number of units and property type
You’ll get the most cash out of a single-family home. Lenders apply lower LTV ratio limits to multifamily homes with two to four units. Lenders may also charge extra fees or higher rates to borrow equity from a condo or manufactured home refinance. Some may even restrict the cash-out LTV ratio on these property types.
How to get the best cash-out refinance rates
Cash-out refinance rates are generally higher than those offered on regular refinances. Turning equity into debt increases the odds you could lose your home to foreclosure, and lenders pass this risk on to you with higher rates.
Here are four steps you can take to get the best rates:
Raise your credit score
Your credit score has a major impact on cash-out refinance rates. A 780 score or higher can get you the lowest rates on a conventional cash-out refinance. Although the minimum requirements are lower for cash-out loans, your interest rate is still affected by your credit score.
Paying off credit card balances and avoiding opening new credit accounts can help you improve your credit score. The extra effort could save you thousands of dollars in interest charges over a 30-year loan term.
Borrow less
Your LTV ratio, which measures how much you’re borrowing compared to your home’s value, is another factor that impacts your cash-out refinance rate. The higher your LTV ratio, the higher your rate will be. One way to borrow less money is by paying down your mortgage principal with a lump sum before refinancing. This can also help make your monthly payments more affordable.
Make home improvements
The right home improvements could increase your home’s value, lower your LTV ratio and lead to a lower cash-out refinance rate. Check Remodeling magazine’s most recent Cost vs. Value Report to learn which improvements give you the best return on every dollar you invest.
Additional Tips on Buying Second Rental Property
When it comes to real estate investing, you can use your equity to purchase a second house or an investment property right away.
If you want to keep the present property as your primary residence, you can use the money as a deposit on another home or buy a new house entirely — as soon as the cash-out refinance is completed.
That indicates you’ll continue to live in the house you’re selling and just use the second home as a getaway or investment property.
Pros and Cons of Cash Out Refinance
Creating equity via property value appreciation, as well as recurrent income and tax benefits, are some of the most compelling reasons to invest in real estate. A cash-out refinance on a rental property converts equity into money, which can be used for a variety of purposes:
- Increasing investment capital and keeping funds on the sidelines while looking for a new rental property.
- Modifying an existing property to boost the requested rents and property value.
- Paying off other real estate debts or high-interest private debt, then putting the money into a separate saving account to purchase another rental property.
However, before executing a cash-out refinance on a rental property, consider a few drawbacks.
To begin with, a lower interest rate isn’t always a certainty. Make sure to consider how a variation in the interest rate may affect your present property’s income stream. Even though interest is a tax-deductible expense for real estate investors, spending more in interest affects monthly income.
Next, consider any estimated return you anticipate using the cash you withdraw to purchase another rental property. It may sound right not to refinance your present loan if there isn’t enough potential benefit.
Conclusion
Cash-out refinancing allows homeowners to take advantage of their home’s equity. Borrowing a new mortgage where borrowers can use their existing equity to secure a lump-sum payment is the general procedure. The funds can be used for almost any purpose, including debt repayment and renovation financing.
A cash-out refi should, ideally, result in a cheaper interest rate than your current mortgage. Still, you should assess your unique financial circumstances to determine which option is best for you since borrowing a cash-out refinance carries risk, particularly because the borrower is removing equity from their home and using it as collateral.
So it is important to think about your decision from various perspectives. Whatever loan option you choose, you should think about the all-in costs of each possible option.
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FAQs
Yes, if you qualify. However, you’ll be limited to a lower LTV ratio and should expect a higher interest rate. Lenders limit the LTV ratio for cash-out refinances on investment properties to 75%, meaning you’ll need at least 25% equity after closing.
With a cash-out refinance, you take out a new mortgage that’s for more than you owe on your existing home loan, but less than your home’s current value. At closing, you’ll receive the difference between the new amount borrowed and the loan balance.
A cash-out refinance can make sense if you’re able to get a good interest rate on the new loan. The answer also depends on what you plan to do with the money. Seeking a refinance to fund vacations or a new car isn’t a good idea because you’ll have little to no return on your money. On the other hand, using the money to fund a home renovation can rebuild the equity you’re taking out.
Either way, you’re using your home as collateral for a cash-out refinance, so it’s important to make payments on your new loan on time and in full.
Cash-out refinance rates are typically higher than traditional refinance rates. This is because lenders consider cash-out refinances to be a riskier mortgage product. However, your specific rate will depend on various factors, including your financial situation and market conditions.
Cash-out refinance closing costs and fees are typically 2% to 6% of your loan amount. That means if you take out a $300,000 loan, you could pay up to $18,000 in fees alone.
The amount of cash you can borrow depends on your chosen loan program’s maximum LTV ratio. For example, you can borrow up to 75% of your home’s value with a conventional cash-out refinance.
With a conventional loan, you’ll need to have owned the house for at least six months to qualify for a cash-out refinance. You can’t do a cash-out refinance on a VA loan until you’ve met a 210-day seasoning requirement or made six monthly payments, whichever is longer. With an FHA loan, you aren’t eligible for a cash-out refinance for 12 months. With all of these, there are exceptions for circumstances like divorce or inheritance.
No. Since this cash is considered a loan, it’s not subject to income tax. However, depending on how you spend the cash, you might be able to write off the interest you pay.
Generally, you can deduct the interest up to IRS limits if you spend the money on permanent projects that add value to your home. Check with a tax professional, but those can include adding a bedroom, replacing your roof or installing a swimming pool. Routine repairs or painting typically don’t count because they don’t increase your home’s value.
If you use the cash for reasons outside of home improvement, such as tuition payments or debt consolidation, you can’t deduct the interest.
