A lot of people buy an investment property, rent it out and then… that’s it.

They pay the mortgage every month and eventually pay it off. Sounds great, right?!

**Wrong…**

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?

## What is a Cash Out Refinance?

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.

## How Does a Cash Out Refinance Work?

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 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.

## Compare Cash Out Refinance to Paying The Loan Down

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.

### Doing a Cash Out Refinance

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%

## Is Paying Off a Loan or Doing a Cash Out Refinance Better?

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.

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!

## Back to My Situation

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:

- Any appreciation on both properties
- Reduced operating costs due to economies of scale
- Overall increased revenue
- Even more equity paydown
- Even more tax incentives due to depreciation

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?**

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