How to Do a Cash-Out Refinance on an Investment Property

When you’re a real estate investor who wants to make improvements on your investment property or you need funds for other projects, a cash-out refinance may be a good option to consider.  With a cash-out refinance, you can borrow against the equity in your property and receive a lump sum to put toward other projects, like adding another investment property, paying off debt, or starting a business. Make sure you weigh the benefits and risks before you decide whether this is the right financial choice for you. Learn how a cash-out refinance for an investment property works, what requirements you’ll need to meet, and crucial elements to consider before you take on an investment property cash-out loan.
 

What is a cash-out refinance for an investment property?

A cash-out refinance allows you to replace your current mortgage on an investment property with a new loan that’s larger than the existing balance. Investors can use the equity they already have in the property as cash.

“Cash-out refinancing uses the equity in your property to provide liquid capital for reinvestment,” says Tim Choate, founder and CEO of RedAwning.com, who’s worked in the real estate investment and vacation rental space for over a decade. For example, you might use the funds to acquire additional properties which can diversify your income streams, he said.

“One common motive is to access the property’s built-up equity to fund further investments, enabling them to expand their real estate portfolio without liquidating current assets,” says Michael Ligon, co-founder and principal investor at The Ligon Group. Other motivations include consolidating debt or securing funds for personal financial needs, Ligon adds.
 

How much equity do you need for a cash-out refinance?

In general, lenders want you to keep a certain amount of equity in the property — often at least 25% for an investment property. That built-up equity shows the lender you have a financial stake in the property and are less likely to default. 
 

Eligibility requirements for an investment property cash-out refinance

These are the typical cash-out refinance requirements to ensure you meet before you apply:

• Credit score: A score of 680 or higher is typically required for competitive rates.
• Debt-to-income ratio (DTI): This describes how your monthly debt payments compare to your income. Some lenders may allow up to 45%, but many lenders will offer lower rates if your DTI is below 36%. A low DTI demonstrates financial stability because you are spending less of your income on debts and are more likely to afford the additional mortgage payment.
• Equity: At least 25% to 30% post-refinance.
• Rental income documentation: Lenders want to see proof that the property generates enough cash flow.
• Seasoning period: For a cash-out refinance, many lenders require you to wait at least six months after purchasing the property.

Another component the lender will look at is a loan-to-value ratio, also called LTV. This compares your current mortgage balance against the property cost, or how much you can borrow compared to the overall value. The maximum number most lenders will allow this number to be is 70% to 75%. This number can vary depending on the lender you’re working with, the type of rental property, and your financial profile.

“LTV is simple math,” says Paul Gabrail of Everything Money on YouTube. “If you own a property worth $100,000 with mortgage debt of $75,000, it’s unlikely you will be able to cash out refinance because LTV is already at 75%. But, if you have a property worth $300,000 with debt of $75,000, the LTV is at 25% of the current property value and much more favorable for cash out refinancing.”

Maintaining a low LTV can also help you achieve better terms, says C.L. Mike Schmidt, a lawyer at Schmidt & Clark LLP. “I advise my clients to keep their LTV as low as possible to increase their chances of approval,” Schmidt says.

Pros and cons of cash-out refinancing an investment property

Before you make any large financial decision, it’s best to put the pros and cons against each other to ensure it’s a wise move right now and in the future:

Pros

• Access to cash: “Higher rental income has come from clients using refinance cash to enhance amenities like energy-efficient windows or modernizing kitchens,” Schmidt says.
• Tax-free cash: Generally, cash-out refinance proceeds are not considered taxable income since the money is structured as a loan rather than earned income. “Since the cash you take out is tax-free, it’s ideal if you’re looking to expand your real estate portfolio or increase your cash flow,” Gabrail said.
• Lower cost than a personal loan: If the overall amount you’re refinancing for — including closing costs — is less than taking out a personal loan, this could be a wise move and borrowers can save money over time, said Schmidt.

Cons

• Higher debt levels: Some investors take on more debt than their properties can support, which can lead to financial trouble, Gabrail said. You have to make sure you can handle the new payments — and the closing costs of this loan refinance.
• Cash flow challenges: Having higher monthly payments could strain cash flow, especially during periods of rental vacancy or if you’re facing unexpected maintenance costs, Choate said.
• Refinancing costs: Real estate investors need to factor in other expenses, like high closing costs or prepayment penalties that could lead to higher payment amounts than the borrower anticipated.

How to use cash from a cash-out refinance on investment property

There are a number of ways a cash-out refi on an investment property can help your financial bottom line:

• Renovate properties: Upgrades like landscaping, adding modern features, and expanding the square footage can increase your rental income.
• You can expand your portfolio: Purchase new properties with the money to add to your real estate portfolio.
• Consolidate debt: Replace high-interest debt — particularly credit cards — with a single, lower-rate mortgage.

“Run the numbers carefully,” Gabrail says. “If the loan’s rates are higher than your current mortgage, make sure the return on the investment justifies the refinance.”

If the improvements you plan to make do not increase the value or income potential of the property, it’s not worth it, says Schmidt.