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A lot of people buy an investment property, rent it out and then they pay the mortgage every month and eventually pay it off. Sounds like a great retirement plan, right?!
The interesting thing about investment property is that you usually don’t want to pay off your loans.
Recently, I decided to pursue a cash-out refinance of one of my properties.I purchased it in 2012 and it’s appreciated quite substantially since then. I owe about $106,000 on it, but it’s worth at least $225,000 meaning my LTV is around 47%.
Though the cash flow is amazing, I have around $120,000 in equity I could be using for something else.
But, should I do the cash out refinance or just leave it alone?
In it’s simplest terms, a cash-out refinance is simply a new loan that pays off the original loan in the process.
The idea is that you don’t want to have a first lien and a second lien because the second mortgage usually has a shorter repayment period and higher interest.
Instead, you refinance the entire loan and a low rate, pay off the original balance, and pocket the rest.
Let’s say you have a 75% LTV loan where the house is worth $100,000 and your loan is $75,000.
Now, you do some work or the market changes and your property is now worth $125,000. You have two options to refinance.
The first option is to get a second mortgage for the difference – in this example, your new 75% would get you to $93,750 which is $18,750 for a second mortgage.
Let’s do some quick numbers. Let’s say you have a 30-year mortgage at 5%.
Total principal and interest = $403
The second mortgage is shorter and at a slightly higher interest rate, let’s say 20 years and 5.5%
Total principal and interest = $ 129
Total = $532
Option # 2 is a cash-out refi.
Your new 75% LTV loan would let you borrow $93,750 for 30 years at 5%.
Total Principal and interest = $503.
So your total payment is about $30 less/month. Obviously, the cash out refinance makes more sense.
It really comes down to two things. First, they may not understand how returns are calculated or second, it may be part of a risk mitigation strategy.
So, people who pay down mortgages are either really savvy or have no idea what’s going on.
Alright, I’m exaggerating a bit, but it’s kind of strange to juxtapose the two, right?
Most people consider real estate to be like a bank. You park money in it, it grows fast enough to cover inflation (plus some more if you’re in a good market). To most people, it’s like a forced savings plan.
Your tenants pay the bills and maybe you get a few bucks out of it, but in the long run, the value is in the building.
After 20 or 30 years of paying down the mortgage, you’ll have an asset that is completely paid off and then the cash flow will be great! Instead of paying say, $1,000 per month, you’ll get to pocket that and it will pay for your retirement.
Not a bad strategy, right?
Real estate is beneficial for 5 reasons – income from cash flow, depreciation effect on taxes, equity paydown by tenants, appreciation, and leveraged returns,
These benefits are offset by risks – bad tenants, insects, weather, economy, changing preferences, etc.
There are numerous ways to offset risk in real estate. You can get good property management, find real estate that has broad appeal, and insure against weather among other things.
But, the biggest way to dramatically reduce risk is to deleverage.
Yes, that’s right. Lower leverage means lower risk.
Lower leverage means less debt. Less debt means lower debt service. Lower debt service means you can have lower cash flow and still cover the operating costs.
When investors are starting off, they are in the growth phase. This is where they are buying anything and everything, adding a lot of value and working hard.
Eventually, this gets old and the investor wants to sustain what they have. They may seek some opportunistic investments to still achieve some growth, but generally, they are focused on just maintaining what they have.
Eventually, the investor wants to deleverage and/or divest. They will sell the properties with the lowest yields to reinvest the capital in safer investments. They may also deleverage the entire portfolio by paying down some debt or paying off some assets completely.
This all happens because people age. Older investors are generally focused on asset preservation, as the time horizon to recover losses may exceed their remaining lifespan, so taking large risks won’t make sense.
An investor that is 30 can take a huge hit that takes 10 years to recover from because they have 50+ years in their horizon.
So, a savvy investor will utilize leverage to maximize returns during the growth phase, and deleverage to reduce risk as the portfolio ages.
Let’s go back to the 2 examples above. There is also the third option.
Option #3 is to completely pay off the mortgage.
Let’s just completely take appreciation out of the picture for a moment (houses don’t actually appreciate in the long run, anyhow) and just focus on the cash flow of a rental property.
Just to keep it all super simple, let’s say your property is rented for $1,250 and you have monthly operating costs of $500. This leaves $750 for your net operating income.
If you have a loan balance of the original $75k ($403/month payment), this leaves you with cash flow of $347/month.
You have a total equity of $125,000 – $75,000 which is $50k.
So, your total return on equity is 8.3%
If you pay the mortgage off completely, you’ll have $750 in cash flow but $125,000 in equity. Your ROE would be:
$750*12 / $125,000 = 7.2%
Your return DROPS by paying it off.
Now, your other option is to cash out refi. You’ll have a total equity of $31,250 and have a total cash flow of $750 – $503 = $247.
$247*12 / $31,250 = 9.48%
The obvious answer is that the cash out refinance gives you a much higher return on your equity. That’s why you should usually try to refinance loans.
But, only if you have a place to put the money! If you cash out and put the money into a bank account, your overall return will drop. For example
You cash out and put $18,750 into a bank account at 1% interest.
The total return on savings account – $187.5
Total cash flow from investment property – $2,964
Total return – $3,151.5 / $50,000 = 6.3%
So, you only want to refinance if you have a place to invest the cash!
Assuming I get a 75% LTV loan on the property, I can pull out roughly $62,000 in cash from the deal.
As I showed in the example above, my cash flow will drop but the total ROE will skyrocket.
But, only if I have a place to put the money.
I’ve put a property under agreement nearby that has a total cost of $250,000 and requires a down payment of… $62,500.
So, I’ll be leveraging all the equity from one deal into the purchase of another deal.
Now, I’ll get:
The negative is that I will be extending out my payments by 5 years and will also incur additional debt on a new property. But, since these are all covered by rents, the risk is limited and acceptable.
So, this is a deal with very little downside and an extremely high upside potential.
You can see how powerful the cash out refinance can be!
Now it’s your turn, do you think you should cash out refinance a deal or pay off the loan?
Eric is an investor that achieved financial independence at the age of 30. He started in 2009 with the purchase of his first triplex and now owns over 470 units. He spends his time with his family, growing his businesses, diversifying his income, and teaching others how to achieve financial independence through real estate. Eric has been seen on Forbes, Trulia, WiseBread, TheStreet, and other financial publications.
I started out as a full-time student, over $60,000 in debt, and didn't even have a full-time job (two part-time jobs).
Learn the system I used to create a 6-figure passive income.
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