Credit is the lifeblood of modern society. Wise real estate investors know how to make the most of available credit, and they know when not to put their assets at too high a risk. Lenders use the term “cash-out refinance” when an owner uses equity in a property to invest in a new acquisition.
The Pros of Refinancing
The main reason for a cash-out refinance is to add to your portfolio. In most cases the longer you have owned a property, the greater the equity. Rental income will have reduced the principal balance and market forces will have increased the property’s value. Together, the rental unit is worth more than the unpaid principal, so that equity can be used to invest in another unit to rent out. That new unit will generate rental income and, all being well, will increase in market value.
Two units generating income, and appreciating in value, together, will enable a third to be purchased.
The Cons of Refinancing
The cons of growing an investment portfolio by refinancing are three-fold:
- The initial costs may be too high. The new loan to provide the cash to reinvest, and the closing costs on the new investment may negatively affect cash availability. Unanticipated major repairs on existing properties added to the refi and acquisition costs may create an immediate problem.
- The market may drop as it did in the 2000s. Falling market values may result in a lender calling in a portion of outstanding loans in order to keep the loan to value (LTV) percentage at the original level.
- Vacancy rates may increase, resulting in poor cash flow compared to the ongoing fixed costs which still have to be paid.
Working the Strategy
If the current and potential income plus the likely market value make refinancing to reinvest a sound idea, then working the strategy is fairly straightforward. Know the rules and the project should succeed.
- Underwriting is more stringent for a cash-out, re-investment, so it pays to understand the basics, and it also pays to shop around. Some lenders work to Fannie May or Freddie Mac standards, and some maintain in-house loan portfolios.
- Lenders may require a higher FICO score, depending on the amount of the cash-out refi.
- Know the cash reserves your chosen lender may require, excluding anything received from the transaction. Some lenders may want a cash reserve equal to up to 12 months of the new repayment figure.
- Depending on how many other properties are owned, both primary residence and investment properties, the lender may want an amount of the unpaid existing loan balances held in reserve.
- Any existing properties currently for sale, may have to be taken off the market if their equity is being used as collateral against the new loan.
- If the property being used for the refi was a fixer-upper, and the work done has generated the increased value that will act as collateral for the new loan, a lender may require a waiting period before releasing the loan, so committing to a purchase before the loan has been approved may be a mistake. There are exceptions to this, for example, if the fixer-upper was inherited, not purchased.
Using current equity to grow an investment portfolio may make sound business sense. Consider the pros and cons, the know the standards lenders work to, and shop around. Get the financing in place before making an offer to avoid finance delays and an unhappy seller.