June 17, 2012

Should You Refinance a Rental and Maybe Cash Out Equity?

We own 4 rentals and we've got some good equity in some of them.   Two properties we own outright with no debt.  One property has a bit of debt but some equity and the other property isn't doing so well and is a bit underwater unfortunately.    Overall we're certainly positive equity by a large margin.   Right now we're considering refinancing a loan and maybe consolidating two loans.   That would give us better cash flow and a lower interest rate.   If we wanted more rental properties then we could even do a cash out refinance and use some equity as a down payment on another property.   My wife and I probably aren't going to keep buying more rentals due to the extra work it takes to run them.   So for us we'll likely just consolidate loans at a lower rate. 

There are situations where cashing out your rental property equity can by using a cash out refinance can be a good idea. 

Cheap Debt is Appealing
Today debt is fairly cheap so taking on more debt for rental investments might be a good deal.  Right now we've got very low interest rates and you can finance a rental for 4.5% to 5% range.  Typically rental mortgages are a little more expensive than primary owner occupied residences which I understand is due to a bit higher default risks.  But todays rates are pretty low and 4-5% is pretty reasonable interest to pay.    On the other hand if debt was more expensive then I don't think I'd be signing up to pay 7% or 8% or more longer term.   Todays low interest rates make refinancing particularly appealing.

Cashing out Should be for a GOOD reason
Generally I would only be cashing out equity on a rental if you have a very good purpose for it.   You shouldn't be cashing out equity to go buy a fancy boat or so you can blow it in Vegas.    I'd make sure your purpose for the cash is a good investment.   Personally I think the primary good reason to cash out equity from a rental is to acquire more rental properties and increase your investment and maybe maximize the rate of return on your equity.    If you have other high interest rate debts like credit card debts then rental equity might be a good way to pay off such debts.   You may also want to use equity from a rental to finance some other form of investment such as starting a small business.

Hows it Work, an Example

Lets say that 10 years ago you bought a rental with a 20% down payment.  You paid $100,000 for the property and put $20,000 down.  You had a 30 year fixed loan with 6% interest.   Your mortgage runs about $480 plus another $300 in expenses.  With it renting at $1000 you're netting a cash flow of $220.   Doesn't seem bad for that $20,000 down.  However the property has appreciated to $125,000 and you've whittled away the principal on the mortgage down to about $65,000 so you now have about $60,000 in equity.   That $60k in equity is only earning you a $2640 annual cash flow.    This might be a reasonable situation to refinance and do a cash out if you had a desire to buy another rental.   You could refinance that loan down to 75% LTV and then have a new $93,750 mortgage  and $28,750 in cash.   That cash would be enough to buy another property for around $100,000 with 25% down.  

Start : One property worth $125,000 and $65,000 remaining on the mortgage.  $60,000 in equity netting $2640 cash flow.
Step 1 : Refinance and cash out existing loan:  Original property now has $93,750 loan at 4.5% and a mortgage of $475.   Positive cash flow is now $225/mo or $2700/year.   Thats a return of 8.6% on your equity.  Plus the cash out nets you $28,750 in cash.
Step 2 : Buy 2nd property for $100,000 with $25,000 down.   This property will cost you $380/mo. for the mortgage and $300 in other expenses and rents for $900.   Now you've got $220 /mo. cash flow on a $25,000 equity.   Thats about 10.5% return on equity.

So you go from one property with $60,000 in equity and $2640 cash flow giving you about 4.4% return to having two properties with about $60,000 equity and $5340 in cash flow and 8.9% total return.    Sounds pretty good right?  

The Negatives
On the other hand with the original property you were only 20 years from having it paid off in full and only had to manage one unit.  With the refinance and second property purchase you now need 30 more years to pay off the mortgages and it will take twice the work.   And there is also the risk that your rentals could drop in value.   Lets say you did the maneuver above back in 2007 right before the real estate market crumbled.   If you lost 25% value in your homes they would have gone from $125,000 and $100,000 to $93k and $75k and you'd effectively have lost all your equity.    But if you'd instead kept the original loan and single property your equity would still be around $28k.

Paying down the Mortgage is a Good Plan too

One train of thought on rentals is to just pay off the mortgages and then own the properties free and clear.  My father did this and it worked well for him.    He paid off the mortgages gradually over many years and then eventually owned all his rentals free and clear.  Now he has a pretty good income stream from the properties and no debt to worry about.    I think this is a fairly safe and worry free strategy.   You aren't maximizing the return on your equity but you are taking low risk.


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