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?!
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?