As soon as people realize they can use their home to make money, and not by renting out rooms, they become interested. And most anyone who owns a home they bought before 2020 has seen its value increase as houses across the nation have experienced double-digit price growth year over year since 2019, or pre-pandemic. So, what's the surprising method? A cash-out refinance.
What is a cash-out refinance?
A cash-out refinance is a method of using the equity in your home for any purpose you wish. You take out a new mortgage loan for more than what you owe. The overage is your cash, which you can use to buy another property or make a down payment on one. Other popular uses of a cash-out refinance include debt consolidation, home renovation, and home repairs. Although you can use the cash for a vacation or something frivolous, most financial advisors recommend against doing that -- if you fall on bad times and can no longer afford the mortgage payment, you could lose your home.
Image source. Getty Images.
I've used this method successfully
I bought my last rental property by doing a cash-out refinance. It was the summer of 2020, when house prices were starting to rise and mortgage interest rates were at an all-time low, around 2.5% for a 15-year mortgage. I was going to refinance at that rate no matter what, and it happened to be the perfect time to take some cash from the home to buy another property.
You might want to consider doing this
If you own a home and have a significant amount of equity in it -- 20% or more -- you might want to do a cash-out refinance, too. Mortgage interest rates are still low, so chances are you won't be paying a higher interest rate. You might even lower your interest rate.
Be aware of risks and drawbacks
There are some risks and drawbacks of cash-out refinancing, in general, you should be aware of.
- They're expensive, typically running between 2% and 5% of the new loan amount.
- You start your mortgage over from scratch. However, you could change the terms to a 15-year mortgage if you don't want to commit to another 30-year mortgage.
- Homes can depreciate. (Although, at the time of this writing, March 2022, there are no significant price drops on the horizon.) If your home depreciates, you might wind up owing more than the home is worth.
- You could lose your home if you can no longer make the new loan payments, maybe because of a job loss or some other catastrophic situation.
Over-leveraging yourself
There's another big risk of using the cash-out refinance method to buy rental properties -- over-leveraging yourself. This could easily happen if you start doing lots of deals at once, each time pulling equity from one property to buy another. If you don't have enough cash flow/income coming in to allow you to keep up with a sort of home-juggling act, the whole thing can come crashing to the ground, possibly leaving you with nothing.
Being over-leveraged to that extent can happen if you lose a source of income you count on, such as your job. But it could also happen from having vacancies or from renting to tenants who stop paying rent (eviction can be a slow and expensive process).
Leveraging your money works best when you don't spread yourself too thin. It helps to keep significant cash reserves in a bank account, such as six months' worth of expenses for each property. That could get you through a hard period, so you won't be forced to sell at an inopportune time.
Get the cash first
In times when many people are doing cash-out refinances, like now, it's better to get the loan transaction completed before looking for properties to buy. I made the mistake of first finding a property and then starting the process, thinking it shouldn't take longer than 45 days, maximum (and probably not even that long), to get my cash. I was wrong. In my case, it took almost three months for the loan to close. I was able to save the deal by borrowing money from other sources as a bridge loan. But the process was stressful, to say the least.
How to qualify
To qualify for a cash-out refinance from most mortgage lenders, you must meet the following conditions:
- You need to keep 20% of your home's equity, meaning you'll be able to pull a maximum of 80% equity from the home.
- Most lenders require you to have a credit score of at least 620.
- You need a source of steady income.
- Your debt-to-income ratio (DTI) must be below 43%.
If you qualify, a cash-out refinance might be the way to fund your next real estate deal.
