Can I Cash Out Refinance a Rental Property?
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Originally Posted On: https://www.dohardmoney.com/can-i-cash-out-refinance-a-rental-property/
Many real estate investors have done cash out refinances on their primary residences. But, not as many have tried to do this with an investment. For this reason, new real estate investors often ask me: Ryan, can I cash out refinance a rental property?
Yes, you absolutely can cash out refinance a rental property. But, you need to deal with several additional challenges: 1) not all lenders will do this, 2) you’ll likely receive a higher interest rate, and 3) lenders more closely scrutinize home values with cash out refinances for rental properties.
I’ll use this article to cover the details of cash out refinances for rental properties. Specifically, I’ll dive into the following topics:
- What’s a Cash Out Refinance?
- Cash Out Refinance with a Rental Property
- Major Challenges to Rental Property Cash Out Refinances
- Refinances and BRRR Investors
- How The Do Hard Money Team Supports BRRR Investors
- Final Thoughts
What’s a Cash Out Refinance?
Real estate investors frequently throw around the phrase cash out refinance, but I want to actually take a moment to define it. As the name suggests, a cash out refinance involves you receiving some amount of cash as part of the transaction.
Most refinances qualify as rate and term refinances. This means that only two things change between the original loan and the new one: the interest rate (the rate) and the length of the loan (the term). For example, assume you have $200,000 remaining on a 30-year, 4.25% mortgage on your primary residence. Due to the fact that you’ve owned the home for ten years, you’ve paid off a large portion of the original loan balance. And, with interest rates at historic lows, you realize you can get a much lower interest rate with a refinance.
If you refinance that $200,000 remaining loan balance into a new $200,000 15-year, 2.25% loan, that would qualify as a rate and term refinance. All you’ve done is changed the rate from 4.25% to 2.25% and the term from 20 years remaining on a 30-year loan to a new 15-year term.
On the other hand, let’s say that your home has a current market value of $450,000. With a $200,000 mortgage balance, you’d have $250,000 in equity in the property ($450,000 value minus $200,000 loan balance). To access some of that equity, you could complete a cash out refinance. Most lenders will provide a cash out refinance up to 80% loan-to-value (LTV). This means that, in this example, you could receive a refinance loan up to $360,000 ($450,000 value times 80%). But, since you have a current mortgage balance, the first $200,000 of your new loan would go to paying off that balance, and you would pocket the remaining $160,000 as cash (ignoring transaction costs).
And, there are absolutely no limits on what you can do with cash out refinance proceeds, as it’s your money. If you want to blow it all on a trip to Las Vegas, you can (though I highly advise against this sort of financial decision). More commonly, real estate investors view cash out refinance proceeds as capital for their next deals.
But, you have hard limits to the amount of cash you can take out of your primary residence, that is, 80% LTV of the appraised value minus the current mortgage balance. This leads investors to seek alternatives—cash out refinancing rental properties.
Cash Out Refinance with a Rental Property
But, can you cash out refinance a rental property? Yes, you absolutely can! However, investors need to understand a few additional considerations. Most importantly, not all lenders will offer this sort of refinance. Accordingly, when searching for a lender that will, it helps to understand how lenders view different sorts of refinances—as rate and term or cash out.
I’ll outline three potential scenarios for rental property refinances. Assume for each one the investor has a $100,000 balance and 20 years remaining on a 30-year original mortgage.
Scenario 1 – Rate and Term Refinance
In this first scenario, the investor wants to lower the interest rate but doesn’t need any cash. As a result, he refinances the current mortgage into a new $100,000, 15-year mortgage that reduces his interest rate by 2%. Clearly, this scenario represents a rate and term refinance, as only the interest rate and length of the loan changed without any cash going to the investor.
Scenario 2 – Cash Out Refinance
Next, assume the same investor needs $20,000 to repair a roof, and he wants to access the property’s existing equity to do so. He also decides to refinance, but his new loan balance will be $120,000, as he’s taking $20,000 in cash above the old mortgage balance during the refinance transaction. This represents an obvious cash out refinance, as the investor receives cash during the refinance.
Scenario 3 – Still a Cash Out Refinance
This final scenario confuses some investors, which is why I want to highlight it. Say that this investor also needed $20,000 for roof repairs. But, rather than wait to complete a cash out refinance for the funds, he pays for it on a credit card. Then, he plans on refinancing his current mortgage into a larger one, with the difference paying off the $20,000 credit card balance from the roof repairs.
Lenders still consider this a cash out refinance. Even if you take the proceeds and immediately use them to pay off a credit card or other loan, lenders consider you to have received cash from the refinance. I emphasize this, because it can be difficult to find lenders willing to do cash out refinances on rental properties. And, I want to make sure investors don’t make the mistake of thinking they’re asking for a rate and term refinance when, in fact, they require a cash out one.
Major Challenges to Rental Property Cash Out Refinances
When applying for a rental property cash out refinance, investors need to understand four associated challenges. None of these items mean you can’t—or shouldn’t—complete a cash out refinance. Rather, armed with this information, you’ll be better prepared to undertake the process if you decide it makes sense.
Challenge 1: Increased Home Value Scrutiny
Over the past several years, lenders have loosened appraisal requirements. And, this loosening has accelerated in the COVID-19 era. Whereas lenders used to require full appraisals, with the professional appraiser entering the property, many now allow “drive-by appraisals” that don’t include entry to the property. First, the proliferation of online property data has made these appraisals more reliable. And second, COVID-19 concerns have led to many lenders trying to avoid the need to put strangers into a borrower’s home.
But, this loosening of requirements has not extended to rental property cash out refinance appraisals. Banks tend to view these loans as riskier than rate and term refinances, so they will more closely scrutinize the home’s value before approving a final loan amount. For this reason, you can anticipate a full appraisal during the cash out refinance process—no abbreviated “drive by” ones.
Challenge 2: Higher Interest Rates
Related to risk, lenders typically charge the highest interest rates for rental property cash out refinances. Primary residence refinances command the lowest rates, then rate and term refinances for rental properties, with the cash out ones for rentals having the highest rates.
For investors, these increased rates can lead to significantly higher monthly payments. And, investors should measure these increased payments against the potential returns from investing the cash out refinance proceeds. For example, assume an investor is deciding between a $250,000 rate and term refinance, and a $275,000 cash out refinance—both 15-year terms. While spreads vary, it’s not uncommon to see a half percentage point difference between these two loan products.
For the sake of example, assume this investor can receive a 3.75% rate on the rate and term refinance, and a 4.25% rate on the cash out one. With these loan balances and terms for a 15-year loan, the investor would need to pay just over $250/month more for the cash out refinance. Accordingly, he or she would need to determine whether the benefit of the $25,000 cash out outweighs the additional monthly payment.
Challenge 3: Fewer Available Lenders
I’ve mentioned it above, but it warrants repeating. There are far fewer lenders willing to do cash out refinances for rental properties than ones willing to do rate and term ones. This doesn’t mean it’s not possible—just more challenging to find willing lenders.
Frequently, national banks won’t offer these services. But, local credit unions often have more flexibility with loan origination. I’ve personally had great experiences with these institutions. Additionally, if you’re looking for a lender willing to do this sort of refinance, working with a mortgage broker can help.
These organizations don’t originate loans themselves. Rather, brokers connect borrowers with lenders. As a result, they tend to have contacts with tons of different types of lenders. If you explain to mortgage brokers that you’d like to complete a cash out refinance on a rental property, they’ll likely be able to connect you with a couple different options.
Challenge 4: (Potentially) Increased Total Interest Payments
You’ll have to run the numbers on your specific refinance options, but a cash out refinance will likely increase your total interest payments over the life of the loan. For instance, let’s use the same options from the above 15-year refinance scenarios ($275,000 cash-out at 4.25% versus $250,000 rate and term at 3.75%).
With these numbers—and assuming no prepayments—the cash out refinance loan would require just over $21,000 more in lifetime interest payments than the rate and term one. While you can certainly justify this financing cost if you have a good use for the $25,000 from the cash out refinance, you should absolutely consider it when comparing refinance options.
Refinances and BRRR Investors
Refinances prove particularly important to BRRR investors, as successfully completing this real estate strategy depends on refinancing a loan. But, once again, investors should differentiate between rate and term and cash out refinances.
With a BRRR deal, investors complete the following steps:
- Buy: Investors purchase a property—typically a distressed one in need of repairs. If they don’t have the capital for an all-cash deal, investors will use a hard money loan to purchase these properties. These are short-term, higher-interest loans designed as temporary solutions before an investor can secure long-term financing.
- Rehab: Once they’ve purchased this property, investors then renovate it to a level that will appeal to potential tenants. Normally, investors use the hard money loan proceeds to finance this rehab period in addition to the initial acquisition.
- Rent: Following the rehab period, BRRR investors market and lease the property to high-quality, long-term tenants.
- Refinance: With tenants in place, investors can then refinance the short-term hard money loan into a long-term, conventional mortgage. This is critical to the strategy. As stated, hard money loans are designed for short-term use, and they have very high interest rates. The longer a BRRR investor holds this loan, the greater the interest expense burden. Therefore, investors use the refinance proceeds from the new, long-term loan to pay off the hard money loan balance.
BRRR investors should take two important items away from this. First, while seemingly different, a refinance from a hard money loan into a long-term mortgage still qualifies as a rate and term refinance. You only lower the interest rate and extend the term—don’t let the fact that it’s a refinance from a hard money loan concern you. And, as a result, far more lenders will complete this sort of refinance.
Second, if BRRR investors do want to take cash out of the deal during the final step, they will need to complete a cash out refinance. And, due to the shortage of lenders willing to do this for a rental property, I highly recommend that investors identify their permanent lender before beginning a deal. You can do this by A) identifying a lender willing to do cash out refinances for rental properties, and B) applying for refinance pre-qualification prior to a BRRR deal. That way, once you identify a property that fits your BRRR criteria, you can use a hard money loan to move on it with confidence, knowing that you have a long-term mortgage lender confirmed.
How The Do Hard Money Team Supports BRRR Investors
In addition to the importance of finding a lender to complete the BRRR refinance, these investors need to find quality deals. More precisely, if investors hope to find deals that require no money down, they need to be really good deals.
Here’s how it works. Hard money lenders will provide loans based on a distressed property’s after-repair value, or ARV. In other words, they look at what a property will be worth—not what it’s worth now. And, while we can’t speak for other lenders, Do Hard Money will lend up to 70% loan-to-value (LTV) based on this ARV. For instance, say a target property has an ARV of $300,000. We would lend up to $210,000 ($300,000 ARV times 70% LTV).
Next, BRRR investors need to run the numbers to determine whether they can purchase, rehab, and sell this property for less than $210,000. If they can, they don’t need any up-front cash above the hard money loan. If not, they’ll need to identify some gap financing or put cash into the deal, which is where the cash out refinance comes into play.
Most lenders who will provide cash out refinances on rentals will issue up to 80% LTV. In this example, let’s assume that the $300,000 ARV equals the actual currently appraised price following the rehab (not always the case). This would mean that lenders would issue up to $240,000 ($300,000 appraised value times 80% LTV) during the refinance. If $210,000 of that goes to paying off the hard money loan, that leaves $30,000 to put that contributed cash back in the investor’s pocket or pay off the gap financing.
But, once again, finding deals like this can be extremely challenging. To help, we’ve created a tailored software—Investor’s Edge—to help BRRR investors find quality, off-market deals. Specifically, it includes a database of over 160 million potential deals throughout the country. Investors can filter through all of these using their own unique preferences as search parameters. And, once you identify potential deals, you can market directly from Investor’s Edge with pre-filled postcards or voicemails.
Armed with this software, investors can set themselves up for refinance success. With deals found in our database, you’ll be able to put together BRRR budgets where the refinance proceeds cover all of your purchase, rehab, and holding costs—and potentially more.
Not all lenders will do it, but you absolutely can cash out refinance a rental property. However, before doing so, investors should consider the associated challenges. Lenders will more closely scrutinize the home’s value, they’ll charge you a higher interest rate, and you’ll often pay more in total interest than with a rate and term refinance. But, if the cash out benefits outweigh all these challenges, you can and should pursue this refinancing strategy.