Purchasing an investment property is a dream for many, but not always one that is easily financially possible. However, if you already have a home you could cash out some of your equity even if you’re still paying off your home loan.
With rates being so low right now, it could be a great time to think about refinancing your first home to purchase a second. Commonly known as cash out refinancing, this strategy refers to a loan taken out on a property that is already owned. You are effectively using the home equity that has built up over several years to help purchase a second home. There are a number of benefits and disadvantages to this approach, so is it a good idea for you to pursue right now?
How Cash-Out Refinancing Works
A cash out refinancing loan effectively replaces your current property loan with a new one that is higher than the original loan balance. The difference between the two loan amounts is withdrawn in cash, which the investor can put toward a down payment on a new property.
Because you will be withdrawing a portion of your homes equity in cash, you could be liable for higher interest rates. This is due to the loan amount increasing – mortgage lenders will typically limit how much you can withdraw to ensure there is still some wiggle room in the equity. You can expect to only be able to withdraw up to 80% of your home value.
Buying An Investment Property
Homeowners can actually build up profits by using the equity they have in their homes by using the cash out amount to purchase an investment property. Depending on the value of your existing home loan, you can use the 80% equity funds you can withdraw from your property to put forward a down payment on a rental property that could have positive ROI from the get go.
But why is this option something that investors should be considering? There are several benefits, namely securing more favorable loan terms and other attractive tax advantages. A cash out refinance can provide the investor with a better interest rate than a first mortgage would, and when rates are low like they are right now, it can be worthwhile to pursue. In terms of tax, the interest on cash out loans is deductible, as are many of the closing costs you will come across.
One of the most noteworthy advantages of home equity approach is speed. Instead of having to wait for months or years, the investor can quickly get access to the funds they need to snag a good deal.
Important Considerations
When contacting your mortgage lender about a cash out refi, there are a few important things you’ll have to think about first. Conventional Lenders will always require you to keep some portion of equity in your first property should the market or property value ultimately drop.
Buying a rental property using this kind of financing is a quick process that can help you close faster. If you already have a second property purchased using your own funds, you can use a cash-out refinance loan to renovate it.
It is also worth noting that there is a minimum credit score required when applying for a cash out refinance loan. In other words, there are no absolute guarantees that the loan will be granted, but if your credit score is healthy, it is highly likely that your application will be approved.
Why You Should Use A Cash Out Refinance Loan To Buy A Second Home
The primary reason to use a cash out refi to purchase a second home is because it is one of the cheapest forms of debt available to most homeowners.
Unlike business loans, personal loans and hard money loans, the interest rate with a cash-out refinance loan should be comparable to the original interest rate offered on your home.
In addition, the cash out strategy allows you to capitalize on all the untapped equity in your home, without being taxed for doing so. It’s a bit like selling a portion of your house, but without incurring capital gains tax.
Lastly, because you already have a formal relationship with your bank or lending institution, there is far less admin involved with a cash-out refi than an entirely new home loan.
- Allows you to access extremely affordable debt
- Allows you to leverage the power of home appreciation
- You don't get taxed on the equity that you tap into
- You can use the funds to purchase a second home or a rental property
- There is a lot less admin involved than applying for a new home loan
Risks Of Refinancing
Refinancing can be dicey if not approached in the right way. If the investor is using a cash out refinance on a primary property that is still under a mortgage, financing a second home can cause them to lose both if they fall behind on their loan payments. If used like this, cash out refinance loans can introduce the risk of owing more on your original property than it is actually worth.
It’s also important to note that interest rates on this type of financing can be higher and even increase over time. You will need to ensure that you have the funds available to cover an increased mortgage payment every month. If something was to affect your income, such as unexpected unemployment, you could lose both your investment property and your primary home.
Cashing out equity in one property to secure the purchase of a second is a viable option to the investor that approaches the situation carefully. While there are some risks, when managed the right way, there are also significant advantages and with rates at their lowest, there is no better time to consider cash out refinancing. From more flexible terms and interest rates to tax advantages and more, investors should consider this strategy if they want to build wealth with real estate.
Additional Things To Note
There are actually two ways to tap into your home’s equity if the homes value has increased significantly over a period of time.
Method 1: Home Equity Loan
With a home equity loan, the original loan is restructured, resulting in a new fixed monthly payment and a fixed interest rate for the duration of the loan. The borrow can use the difference between the original loan amount and the new loan amount as substantial down payment on another property, or they can put the cash into other assets like stocks and bonds. It is very much up to the homeowner to choose what they will use the cash out refinance to buy. In most cases, property owners will either renovate their existing house, put a down payment on a new house, or use their home equity to fund a business opportunity.
Method 2: Home Equity Line of Credit
When applying for a Home Equity Line of Credit (HELOC), the borrower is issues with a revolving line of credit that typically has a variable interest rate. The HELOC approach is typically used to fund home improvement costs and other expenses that aren’t quite as expensive as purchasing a new home. You are basically turning your home equity into a credit facility that is comparable to a credit card, but with a much lower interest rate. It’s easy to understand why so many borrowers are attracted to this option.