More and more investors are doing cash-out refinances on their rental property.
When done for the right reasons, this strategic financing option can be a perfect way to turn accrued equity into money that can then be used to increase property values, raise rents, and scale up a portfolio.
Here’s everything you need to know about doing a cash-out refinance on your rental property.
Top Reasons Investors Do a Cash-Out Refinance
Over the past five years the median home value of a single-family home in the U.S. has increased by over 57%, according to Zillow (as of November 2021).
Therefore, if you originally purchased a 1,500 square foot home at the then median price of $172,500 ($115 per square foot), your rental property is now potentially worth $270,825 ($181 per square foot).
That means the accumulated equity in your property from appreciation is over $98,000 – and that doesn’t even take into account the reduced principal balance on the mortgage after five years of payments.
It’s true that some people prefer to leave the accumulated equity in the house untouched. However, many professional real estate investors think it makes better business sense to turn their equity into cash and put that "free money" earned from normal appreciation to work by:
- Investing in another rental property to scale up a real estate portfolio
- Diversifying geographically into different markets by becoming a long-distance real estate investor
- Raising capital to participate in a joint venture real estate investment opportunity
- Making improvements or updates to an existing rental property that will justify higher rent and increased yield
- Paying off an existing real estate loan on another property
- Eliminating outstanding personal debt, which is the first step toward reaching financial freedom
Rules for Rental Property Cash-Out Refinancing
Although there are plenty of good reasons for doing a cash-out refinance on your rental property, it’s important to make sure you understand the rules of the game.
Here are the guidelines from Fannie Mae for successfully refinancing your existing loan to pull cash-out of your rental:
- Maximum 75% LTV (loan-to-value) for single-family homes or one-unit properties
- Maximum 70% LTV for 2- to 4-unit properties such as a duplex or triplex
- ARM (adjustable rate mortgage) have LTVs of 65% for one-unit and 60% for 2- to 4-units
- Property listed for sale within the last six months has a maximum LTV of 70%
- Property can not be listed for sale at the time the cash-out refinance loan is applied for
- Property purchased within the last six months is not eligible for a cash-out refinance – however, there are three exceptions
Exceptions to the cash-out refinance rules
Normally you need to wait six months from the date of closing on the property before doing a cash-out refinance. However, there are three exceptions to the six-month rule:
- Property was inherited
- Property was obtained from a legal judgement in a divorce or separation order
- Property qualifies for the delayed financing exception
Delayed financing rule for cash-out refinancing
In addition to the above exceptions, you are still eligible for a cash-out refinance if you purchased the rental property within the last six months if:
- New loan amount does not exceed the original purchase price, excluding any closing costs
- Property was not purchased with mortgage financing
- Source of funds for the purchase can be documented
- Borrower has a closing disclosure or settlement statement with transaction details, including the purchase price of the property
- Purchase between buyer and seller was an “arms-length” transaction, with the seller not having a pre-existing relationship with the buyer or an interest in the sale, except for transacting the sale itself
Fannie Mae vs. Freddie Mac
The rules for a cash-out refinance are slightly different between Fannie Mae and Freddie Mac:
- Single-family or 1-unit 75% LTV fixed rate loan 65% LTV ARM
- 2- to 4-units 70% LTV fixed rate loan 60% LTV ARM
- Single-family or 1-unit 75% LTV fixed rate loan 75% LTV ARM
- 2- to 4-units 70% LTV fixed rate loan 70% LTV ARM
Credit score and cash reserves requirements
There are two additional things to keep in mind if you’re thinking about applying for a cash-out refinance of your rental property.
First, lenders often require a higher minimum FICO score of at least 680-700. That’s because underwriters view loans on investment property as higher risk, especially when the borrower is pulling most of the equity out of the property. However, some lenders are less strict than others, so it can pay to shop around for lenders that have a lower minimum credit score if you don’t already have a mortgage broker or lender as part of your trusted real estate team.
In addition to requiring a higher credit score for a cash-out refinance, lenders normally require that you maintain a cash reserve fund. This protects you and the lender from potential downside risk if cash flow temporarily goes negative due to a longer than normal vacancy period, or if an emergency capital repair suddenly needs to be made.
Minimum reserve amounts vary from lender to lender. Some require anywhere from a few months up to 12 months or more of the future mortgage payment. Other lenders may require you to keep a cash reserve account with a balance of up to 6% of your unpaid loan amount.
Pros and Cons of Doing a Cash-Out Refi
Cash-out refis on a rental property are normally best for investors with higher-than-average credit scores and extra capital on hand. That’s because lenders usually have higher requirements for investment property cash-out refinances than with homes that are owner-occupied.
You should also be prepared to provide the lender with information such as the lease agreement, tenant payment history, profit & loss statement, and balance sheet. These documents and reports demonstrate to the lender how well your rental property is performing financially.
Other pros and cons of doing a cash-out refi on our rental property include:
Pros of a cash-out refinance
- Lock in an interest rate at today’s historical low rates
- Wise use of leverage can increase ROI and cash-on-cash return
- Yield potential double digit return by doing updating that increases property value and justifies a higher rent from tenants
- Increase occupancy length by making tenants want to rent from you long-term
- Grow and diversify your rental property portfolio by using equity to invest in additional rental property
Cons of a cash-out refinance
- Potential for negative cash flow due to over-leveraging and a high loan payment after the cash-out refi
- No immediate use for the funds received from the cash-out while loan fees still have to be paid
- Cash-out refi fees including origination and application fees, appraisal and inspection, title search and insurance fees can reduce the amount of cash at close of escrow
- Agreeing to an ARM (adjustable rate mortgage) that doesn’t match your long-term, buy-and-hold investment strategy since rates and monthly payments can fluctuate
Cash-out refinance vs. a HELOC
The biggest difference between a HELOC – or home equity line of credit – and a cash-out refinance is that a HELOC gives you access to your equity when and if you need it.
On the other hand, when you do a cash-out refinance you receive your equity right away as a lump sum payment. So, you’ll need to put the equity you turned into cash to work right away in order to make the most of your cash-out refinancing.
Other differences between a cash-out refinance and a HELOC include:
- Receive all of your money up front as a lump sum payment
- Cash-out refinancing may be easier to qualify for than a HELOC
- Interest rates on a new loan are usually lower than a home equity line of credit
- Can’t borrow again until you refinance
- New mortgage means ‘resetting the clock’ by having to re-grow your equity in the property
- Longer loan terms of 15 or 30 years mean more interest payments
- Line of credit means you don’t have to use the money right away
- Can borrow again each time the line of credit is paid off
- Closing costs normally less with a HELOC vs. a cash-out refinance
- Interest rates are usually higher and may adjust as rates go up or down
- Lender fees for a HELOC may be higher on a rental property vs. a personal residence
- HELOC on a rental property can be difficult to qualify for as lenders tighten their qualification requirements
Doing a cash-out refinance on a rental property isn’t the right choice for every real estate investor. For example, if you’re planning on selling the property in the not too distant future, the expense of doing a cash-out refi may be greater than the rewards.
However, when done for the right reasons, there are plenty of benefits to refinancing your rental property and pulling cash-out:
- Lock in today’s historically low interest rates with a new loan
- LTVs of up to 75% let you access the maximum amount of accrued equity in your property
- Turn accrued equity into cash you can use to increase property value, raise rents, and generate more cash flow