In Tapping Into Appreciation in A Growing Market, I shared why anyone with equity in their home may want to consider converting that equity into cash in a great market so that equity could be used and reinvested, rather than sitting idle or even worse, lost altogether due to cyclical declines in the market.
I did precisely that with two of my rental properties, and here I share six things you may want to consider when taking steps to refinance your home, single-family investment or multi-family assets.
What is Refinancing?
Before I share what to consider, I will briefly explain what refinancing is. All loans are callable by the mortgage holder, meaning we can call the loan by paying it off and getting into a different loan with more favorable terms. This is a savvy strategy for someone who wants to get a lower payment by avoiding the interest of the current loan or take cash out of the property. Simply put, as the mortgage holder, you are getting rid of one loan and securing financing through another loan (hence, refinancing).
Side note: you do not have to have a loan in the first place to refinance a property. If the property is owned outright, you can go to the bank and get a loan against it. They essentially pay you a percentage of the value of your asset and you will begin issuing payments towards that debt. This has been done in the commercial real estate world for a long time and many people adopt this strategy in single-family homes.
Below are what to consider when you are refinancing:
Interest Rates
Interest rates are the primary reason for one to consider refinancing into a new loan. By obtaining a loan with a lower interest rate, not only is the payment less, but the interest paid over the life of the loan would be less.
Equity
Next to interest rates, equity is another top driver for seeking to refinance. When there is much equity in your rental, there is the opportunity to convert that idle equity into cash by refinancing. In combination with low interest rates, having equity to convert into cash is a great strategy for preserving wealth and obtaining funds for reinvestment.
How Long You Plan To Hold the Property
There are finance costs associated with refinancing. If you already intend to sell your real estate asset in the next few years, it may not make sense to refinance into a new loan at higher debt and pull out cash. You would have to pay finance costs that would be avoidable if you just waited to sell to get cash. However, if you plan to hold the property for longer into the future, rather than sell, refinancing into the lower rate and paying finance costs for the new loan may make sense. Think about your plan and intention for the property as you weigh your options.
In my case, I knew that I intended to keep the rentals for a while and pulling out cash today and lowering my payment due to lower interest rates was ideal.
Balance of Original Mortgage
There must be a simple understanding of how much you owe on your current mortgage and what the payoff amount is. Some loans have a prepayment penalty and you will want to take this into account. The best thing to do is call your current lender and ask for a payoff quote. This will give you the precise payoff amount.
Cash-out Amount
If you intend to pull out cash from your refinance, you must estimate th amount of your new loan, the payoff amount of the original mortage (inclusive of any prepayment penalty), and finance costs with the new lender.
For rental properties, lenders usually agree to a loan-to-value of no more than 75%. That means if you refinance into a new loan and the property is valued at $200,000, the lender will give you a loan for $150,000 (75% of $200,000). Your cash out amount will be net of the new loan, payoff of the old mortgage and any financing fees:
New Loan $
– Pay off old loan
– Financing Costs
Cash Out Amount
New Payment
In working with your lender, understand what the new mortgage payment would be after taking into account the new rate, the amount of the loan and the loan-to-value of the mortgage. It is extremely important to understand your new mortgage payment. As a rental, you must ensure that the property will still cash flow well, meaning income for the rent covers both operating expenses and debt services, leaving cash to pocket at the end. If you take out too high of a loan, the monthly payment may exceed what allows for positive cash flow. In doing your estimates, tweak your loan amount downward (leaving you with less to cash out) as needed in order to ensure there is a balance between how much cash you take out and the monthly payment needed for good cash flow.
Here is my example.
In my recent refinance, I had nearly 90,000 of equity in my house and wanted to convert a portion of that into cash in order to protect that wealth from eroding (in a market downturn), taking advantage of lower rates in the process, and reinvesting those funds into real estate and other assets.
Here are what the numbers look like:
Cash out
Appraised value: $189,000
Loan Value (75% LTV): 141,000
– Payoff of old loan: $103,000
– Financing Costs: $12,000
Cash at closing: $26,000
Cash Flow
Even after pulling out $26,000, because my interest rate had decreased from 4% to 3.5%, my mortgage payment stayed the same, leaving my property’s cash flow was unaffected.
Next Steps
If you are considering refinancing your house or a rental that you own, now may be a great time. Interest rates are at serious lows! At least take the first step by contacting your mortgage lender and explaining your goals for a refinance.
As usual, please reach out with questions.
