Real estate investors who purchased rental property over the last few years have seen home values rise and equity increase. With the demand for good rental property as strong as it is today, many investors believe that the time is right to start growing a real estate portfolio.
Tapping into existing equity is one way investors can raise money for the down payment on another rental property. Keep reading to learn more about how a cash-out refinance on a rental property works and the process for refinancing a rental property.
- Cash-out refinance on a rental property turns accrued equity into cash for reinvestment.
- Rental property refinance loans may have slightly higher interest rates, fees, and lower loan-to-value ratios.
- Obtaining a cash-out refinance rental property loan can be a good way to raise capital for additional investments.
- Delayed financing exception allows investors who originally purchased a property with cash to do a cash-out refinance right away.
What is a Rental Property Cash-Out Refinance?
A cash-out refinance (often referred to simply as a cash-out refi) for rental property works the same way refinancing does for your 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. The cash is yours to do with as you please, such as buying an additional investment property to grow your real estate portfolio.
Things to Know Before Refinancing a Rental Property
There are three things about refinancing rental property that real estate investors should be aware of:
1. Interest rates and fees
Interest rates and loan fees are usually slightly higher than refinancing a primary residence.
That’s because banks generally view an investment property loan as having more risk than an owner-occupied home, and lenders use higher rates and fees to compensate themselves for taking additional risk.
2. Maximum LTV
Lenders typically allow a maximum loan-to-value (LTV) ratio of 75%, which means that you need to have more than 25% equity in your rental property to do a cash-out refinance.
For example, let’s consider a rental property with a current mortgage balance of $75,000 that appraises for $145,000. Your equity is $70,000 (before any loan costs or closing fees), but you’ll need to keep some of that money in the rental property when you refinance it.
Based on an appraised value of $145,000 the maximum refinance loan you could qualify for would be $108,750 ($145,000 x 75%). The difference between the appraised value and the new loan amount is $36,250 ($145,000 – $108,750), which is the amount of equity you would need to keep in the property.
So, instead of having usable equity of $70,000, the actual cash you have available to reinvest would be $33,750 ($70,000 original equity less $36,250 kept in the property after refinancing).
3. Refinancing rules
The rules to qualify for a rental property refinance are more stringent than refinancing your primary residence:
- Minimum borrower credit score set by lenders may be between 680 and 700, although technically Fannie Mae and Freddie Mac may accept a lower FICO score.
- Cash reserves of up to 12 months worth of mortgage payments in a liquid or cash account may be required.
- More than 25% equity in rental property may be required in order to pull cash out because lenders often only allow a maximum LTV of 75%.
- Lenders may require a waiting period of six months from the time of purchase before an investor can refinance a rental property.
How To Do a Cash-Out Refinance on a Rental Property
Here are the general steps to follow when refinancing a rental property to pull cash-out:
1. Gather lender-required documents
- Proof of income, such as pay stubs or bank statements if you are self-employed.
- Copies of W-2, 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 purchased the 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 rental property cash-out refinancing
While lenders can set their own rules for refinancing a rental property, most follow the guidelines set by Fannie Mae and Freddie Mac.
However, some lenders may be willing to work with you on the interest rate and loan fees, depending on your relationship with the bank and the current performance of your rental property.
That’s why it’s a good idea to shop around for a rental property refinance loan by visiting the Stessa Mortgage Center.
3. Lock down the interest rate
Once the application for a cash-out refinance on your rental property has been approved, the lender will normally give you the option of locking down your interest rate.
Interest rate locks vary based on the property and loan type but generally range between 15 and 60 days. Locking down the interest rate allows you time to review the cash-out refinancing terms without having to worry about a change in the interest rates.
Investors who believe that interest rates will decline may choose to float the rate instead of locking it in. On the other hand, locking the interest rate in provides protection in the event that interest rates begin to rise.
4. Proceed with underwriting
The process for underwriting a loan is similar to what you do when screening a prospective tenant. After all of the documents have been received, the underwriter will verify your income, employment history, and assets.
Part of the process for underwriting a cash-out refinance for an investment property also involves ordering an appraisal to determine the fair market value, and inspecting the condition of the property.
If you are currently using Stessa to track the financial performance of your rental property, you can generate informative income statements, net cash flow, and capital expense reports for free.
Financial reports like these can help the appraiser to better understand the true value of your rental property, including the income the property is generating and any improvements and upgrades you’ve made in the last few years.
5. Close on the rental property refinance loan
After the underwriting is complete and your refinance loan is fully approved, the final step is to close on your loan.
A few days prior to loan closing your lender will provide a Closing Disclosure that provides details about your cash-out refinance rental property loan, such as closing costs and fees. At closing, you’ll have the opportunity to review all of the loan documents, ask your lender questions, and verify that the loan charges and interest rate are correct.
Once the loan closes you’ll receive the money from your cash-out refinance, normally within one or two business days.
Types of Cash-Out Refinancing for Rental Property
When refinancing a 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:
Single-family cash-out refinance 75% LTV
Multifamily cash-out refinance (2-4 units) 70% LTV
No-cash-out refinance 75% LTV
Single-family cash-out refinance 75% LTV
Multifamily cash-out refinance (2-4 units) 70% LTV
No-cash-out refinance single-family 85% LTV
No-cash-out refinance multifamily 75% LTV
What is Delayed Financing?
Investors are normally required to wait six months before refinancing a rental property.
However, the delayed financing exception allows real estate investors who originally purchase a rental property with cash to do a cash-out refinance within a few days of closing on the all-cash purchase.
There are four general guidelines for delayed financing of a rental property that was purchased using cash:
- Investors must have paid for the property in cash.
- Source of cash funds used to purchase the property must be documented.
- Any existing liens or loans on the property (such as an outstanding property tax lien) must be paid off when the property is refinanced.
- Lender must conduct a title search on the property to verify the borrower did not use financing when the property was first purchased.
Benefits of Doing a Cash-Out Refinance on Rental Property
Building equity through appreciation in property value – along with recurring income and tax advantages – are three of the main reasons for investing in real estate.
Doing a cash-out refinance on a rental property turns equity into cash that can be used for things such as:
- Raising investment capital and having cash sitting on the sidelines while you search for another rental property.
- Updating an existing property to help raise the asking rents and increase property value.
- Paying off other real estate loans or high-interest personal debt, then redirect the cash flow saved into a special savings account to buy another rental property.
Drawbacks to a Cash-Out Refinance
There are a couple of downsides to consider before doing a cash-out refinance on a rental property.
First, a lower interest rate isn’t always guaranteed. Be sure to analyze how a change in the interest rate will affect the cash flow on your current property. Although interest is a tax-deductible expense for real estate investors, paying more in interest reduces the amount of monthly cash flow.
Secondly, take into account any projected return you expect to receive by using the cash you pull out to buy another rental property. If there isn’t enough potential profit, it may make sense to not refinance your current loan.
Obtaining a cash-out refinance loan for a rental property is a little more difficult than refinancing a primary residence. But for many investors, the cash received is worth the extra effort. By pulling cash-out of one property to use as a down payment on another rental property, real estate investors can have available capital to use as a down payment while they search for their next investment.