One of the key elements to successful real estate investment is a cash-out refinancing of existing property holdings. When should you use this tool?
What is Cash-out Refinancing?
Cash-out refinancing is essentially refinancing your mortgage for a higher principal amount. If you have owned your property for a long period of time, it has most likely appreciated in value. Cash-out refinancing is a way to free up the increase in equity.
4 Reasons For Doing a Cash-out Refinancing
There are 4 primary reasons when you should consider doing a cash-out refinancing, namely;
1) Reduce Your Monthly Payments
If your current mortgage carries a high-interest rate, you can refinance your mortgage, take cash out, AND reduce your monthly payment. If you prefer, you can keep your monthly payment the same and opt for a 15-year amortization instead of the standard 30-year amortization. That would save you thousands of dollars in interest over the term of the mortgage.
2) Pay Down Expensive Debt
If you are carrying credit card debt or other consumer loans that have a high rate of interest, it makes sense to refinance your mortgage and use the cash to pay off any debt has that a higher rate of interest than the new mortgage.
In some cases, the interest expense of the new mortgage is tax-deductible, whereas interest on consumer debt is not.
3) Cash For Home Renovations
Another great reason to do a cash-out refinancing is to pay for renovations to your existing home. Many homeowners will use a HELOC for this purpose. However, if the market value of your home drops or you have made late payments, your HELOC can be frozen or terminated. With a cash-out refinance, you have certainty that you will have the cash to make your planned renovations.
It is important to determine if the renovations you have planned add at least as much or more value to your home than the cost of those renovations. For example, if you are planning to add another bedroom to your house, it will likely add significant value to your home, On the other hand, in some locations, adding a swimming pool could actually decrease the value of your home. This is especially true in northern, colder climates.
4) BRRR Strategy
For real estate investors. Cash-out refinancing is an essential component of this strategy. BRRR is an acronym for Buy, Renovate, Rent, and Refinance. The strategy involves adding more value than the cost of renovations. Once the property is rented and it generates positive cash flow, the mortgage can be refinanced, taking cash out, and repeating the process on another property.
For more information on how the BRRR strategy works, read my post here.
The objective of any cash-out refinancing is to provide a benefit that is greater than the cost of the refinancing. In some cases, the benefit may be subjective. Even then, you should attempt to quantify that benefit in financial terms.
Let’s do a cost-benefit analysis from both a homeowner’s perspective and a real estate investor’s perspective.
The homeowner should ask the following questions before embarking on a cash-out refinancing.
1. What am I going to do with the cash?
We have already covered what you should do with the cash. If you have another reason for doing a cash-out refinancing, such as paying for a luxury vacation or purchasing a new car, you may want to think twice. These 2 examples represent sunk costs that have no long term value. You will be paying for them long after they are just a memory.
2. What are the costs of refinancing?
Refinancing a mortgage is not without significant costs. These costs include appraisal fees, lender fees, escrow, and title fees. You can learn more about refinancing costs here.
In general, the cost of refinancing is about 1% of the value of the new mortgage. In some cases, these costs can be added to the mortgage which would result in less cash out at closing. To calculate the cost of your refinancing, you can go here.
Once you know the cost of refinancing, you should calculate what the payback period is so that you can determine if the refinancing is worth the cost. Let’s look at the following example.
As you can see from the above example, you will recover the cost of refinancing in 16 months based on the savings in interest expense. If the monthly cash savings are used to pay down the mortgage faster, the savings will be even greater over the long term.
3. How long am I going to own the property?
If you are planning to use the cash to pay for renovations to your home, and the increase in value to your home is less than the cost of the renovations, it is important to know how long you will own the property. Should you keep the property for a long time, the increase in market value over time will offset the difference.
Conversely, if you are planning to sell the property in the short term, it makes no sense to make renovations that cost more than the value they will add.
For the real estate investor, there are a different set of questions that need to be answered.
1. Is the Property I Want to Refinance Currently Cash Flow Positive?
Suppose you currently own a property that is generating $400 per month in positive cash flow. At an interest rate of 3.25%, you could refinance your mortgage and take out about $90,000 and your investment property would be cash flow neutral.
2. Is the ROI on the New Investment Greater Than the Interest Expense of the Refinanced Mortgage?
Using the above example, can you invest the $90,000 either as a down payment or down payment plus renovation costs and generate a return that is higher than the interest rate you are paying on the additional $90,000 you cashed out?
For more information on maximizing your ROI, you can read my post here.
3. Do I Still Have Adequate Reserves After I Complete the Cash-out Refinancing?
Investing in real estate is not without risk. That is even truer in the current environment. It is important to have at least 6 months of monthly expenses in a reserve account. Therefore, you should calculate what those reserves should be once the cash-out refinancing is complete. They will most likely have to be revised upward.
Depending on your location and circumstances, it may be prudent to do a cash-out refinancing just to build additional reserves.
The Bottom Line
Cash-out refinancing can be a valuable tool, either as a way to reduce debt servicing costs or as a method to grow your real estate investment portfolio. The objective should always be to create a benefit that is quantifiably greater than the cost.