Mortgages & Creative Financing

Cash-Out Refinance: The Simple Math Behind a HELOC

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BiggerPockets guys and gals, let’s talk about cash-out refinancing. Back by popular demand!

We're going to talk a little bit about the pros and cons, the mechanics, what a refinance is, what a cash-out refinance is. Let's get to it.

OK, the cash-out refinance. Now, we did a video before, discussing a little bit about the cash-out refinance. It got more into the weeds about what it is and how we did it in an example.

Today, we're going to talk a little bit more high level about what a refinance is and how you'd actually go to your bank (provided you have equity in your home) to engage in a cash-out refinance.

The best thing to do when talking about cash-out refinance is to break that down to its simplest form—and that’s just the refinance of a home. A lot of people hear this term, and I think it confuses them. But it really isn’t that complicated.

What Is a Refinance?

It's basically the replacement of an existing mortgage. That's right. It's not a redo. It's not anything more complicated. It's the replacement of your existing mortgage with a new mortgage.

And why would somebody do this?

Oftentimes, what happens is people have a mortgage at a high interest rate compared to today's rates.

So, for example, you might have a mortgage that is at 7.5 percent. Today, you could get it at 4.5 percent. That might be the reason you go to the bank to refinance—you’re achieving that lower rate.

But that's not really what we're talking about today. We're talking specifically about a cash-out refinance. This is slightly different and applies more to real estate investors.

What Is a Cash-Out Refinance?

So, what that is, is we’re trying to take equity that has built up in a property we currently own, and we’re going to use it. And what we’re going to use it for is really up to us. That might be buying a new property, doing renovations to an existing property, or it might be some other strategy with regard to investment.

But ultimately the goal is pulling money out of existing properties.

Related: The 3 Major Reasons It Makes Sense to Refinance a Property

I’ve got an example. Alright, we’ve got our friend Mike. Mike bought a $500,000 duplex. Today, Mike’s property is worth $600,000.

Now, when Mike purchased the property at $500,000, he put 20 percent down (or $100,000).

How many of you know LTV, or loan to value? In this example with Mike, he's got $400K in debt aka the mortgage. He has $100,000 in equity. So, he has an 80/20 LTV.

Good for Mike. That’s fantastic.

money-investor

Mike’s property now is worth $600,000. Bought it at five hundred; it’s now worth six. He built up a $100K worth of equity.

Now what?

What he wants to do is take a portion of that. So, he goes to his bank. Banks are not going to let you take the whole $100K. They’re going to have certain loan to values that you have to stay within. That might be 80/20, that might be 70/30.

In this example, let’s assume that Mike can get an 80/20 loan to value. That means he can take up to 80 percent of his built-up equity.

$100,000 x 0.80 = $80,000

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What he does is he goes down to the bank. The $600,000 of what it’s worth today is appraised by the bank. They agree.

He gets now $80K on his cash-out refinance. But it doesn’t end there, because you really have two options with a cash-out refinance:

  1. You could add to the existing mortgage of $400,000. That would mean that right when he gets that, he starts making monthly payments.
  2. Or he could do something called a cash-out refinance and utilize a line of credit—or a home equity line of credit.

The reason many investors go the HELOC route is if you don't utilize any of that equity—that means you don't actually take money out of the line of credit—you don't pay any interest on it.

The other benefit is that these are interest-only loans. And that just means they're not amortized.

If you have a 4 percent interest rate and you take out $100,000, that’s $4,000 payment for the year. Just the $4K—nothing in addition to that (unless you elect to).

Related: The BRRRR (Buy, Rehab, Rent, Refinance, Repeat) Strategy: A Primer for Investors

So, Mike’s feeling pretty good.

To back up, what did we have here? We had a guy who bought a property for $500K. It’s now worth $600K. Bank told him he could take 80 percent of that gain of that $100,000. He pulled out $80,000.

Now, what do you use that money for?

And that’s where this video is going to fall short—because we’re not talking about what you can use the money for. There’s a number of things you can do with that money.

Like we mentioned, you can go buy more property. You can do renovations. But really, that’s the snapshot of the cash-out refinance: how to do it, where to go and do it, and what you can actually take out of your property.

For simplicity, what I did here is I didn't talk about interest rates. Oftentimes, when you do a cash-out refinance and you do it through a line of credit (a home equity line of credit), it might be the prime rate plus a certain percentage point. I don't want to get too complicated though. I just want to kind of give you an idea at a high level of what a cash-out refinance is.

‘Til next time!

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Questions? Comments?

Let’s talk below.

Jesse Fragale is a commercial real estate broker specializing in tenant representation in the Downtown and Midtown Toronto markets in office leasing and investment sales. Jesse represents clients i...
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    Tom Phelan Real Estate Investor from Key West, FL
    Replied 8 months ago
    In Mike's scenario I would use $52,000 to pay cash for a Duplex in Ohio (actual example) that generates rental income of $1,100. The remainder of the $80,000 credit line, about $30,000, I would reserve for future repairs, vacancy etc. Because I own the Duplex Mortgage Free the net income (subtracting taxes, insurance, utilities, Property Management etc.) I could easily and systematically repay the HELOC, perhaps in an accelerated time frame. When I had repaid the HELOC I would repeat the process. When my first Duplex had sufficient Appreciation (5+ years) I would 1031 Exchange into a higher value property and every 5 - 10 years repeat the 1031 Exchange process without ever coming up with additional cash and forever eliminating paying taxes on long tern capital gains and or recaptured depreciation. Each time I 1031 Exchanged I could buy anywhere in the US thus borrowing Wall Street's mantra; "Diversify". My Ohio Duplex might be 1031 Exchanged in years 5 - 10 for a Triplex in Georgia and then a Fourplex Oklahoma. If young enough, in 20 - years I would probably have an 8-Unit Apartment house generating a respectable Retirement Income. For those of your who have Company 401(k) bloated with stocks and Mutual Funds I would seriously consider borrowing up to 50% of my 401(k)'s balance up to $50,000 and do the same thing.
    Ketan Chand from Cheyenne, Wyoming
    Replied 8 months ago
    No, he has $200,000 in built up equity. He could cash out refinance $160000, not just a mere $80000.
    Ketan Chand from Cheyenne, Wyoming
    Replied 8 months ago
    Nevermind, let me correct myself. For the refinance, 80% of $600000 is $120,000, so since he built up $200000 in equity, the difference between $200,000 and $120000 is $80000 and that's what he walks away with from the refinance. I understand what you were getting at now. Thanks Jesse.
    Ketan Chand from Cheyenne, Wyoming
    Replied 8 months ago
    OMG, I'm having a hard time today. 20% of $600000 is $120000! I'll stop posting now.
    Kyle Deutschmann Lender from Baltimore, MD
    Replied 8 months ago
    Great article Jesse, but I think there's a few things not quite accurate. A cash out refi is not the same as a HELOC. You're right that a refi is just a brand new mortgage with the benefit of either a lower rate, lower payment, shorter term, etc. It becomes a "cash out" refi when you take a lump sum out and/or use the new mortgage to pay off other debt. The benefit of a cash out refi is you get to secure that large amount of money at a low, fixed rate that you can typically only get for a long period of time on a fixed-rate mortgage. A HELOC is generally a 2nd lien and that is correct it is an open line of credit. The benefit of a HELOC is you don't have to take out the cash right away, but the downside is it's like a credit card on your house with a variable rate. A line of credit can be closed suddenly if the property drops in value or if you don't use it, and you typically cannot write off the interest on 2nd mortgages, unless the money is for home improvements. Also, loan-to-value isn't based on the $100k additional equity, it's based on the total loan vs. the value of the property (i.e. 80% of 600k = 480k)
    Cedrick Mahieux New to Real Estate from Austin, TX
    Replied 8 months ago
    Agreed as well. we are talking about Loan to Value, meaning at what value the property is estimated by the bank. Not loan to equity build-up
    Andre Chambers Rental Property Investor from Saint Louis, MO
    Replied 8 months ago
    Right, Mike's "cash out" in this example would be 480K - remaining mortgage balance - closing costs.
    Brendon Sullivan from Belmont, Massachusetts
    Replied 8 months ago
    Are banks usually willing to give a second mortgage after you just borrowed from the equity of the first property? Could he take that $80,000 and use as a downpayment for another 500,000 property or would the banks be skeptical because of his debt to equity ratio?
    Floyd Bonner
    Replied 6 months ago
    Great article. One follow up question, is it possible to do both? Around October 2019 we closed on a cashout refi on our primary resident for cash to finally jump into real estate investing. With the current market uncertainties due to Covid19, we have pressed pause on our search but in the meantime plan to use this time to further educate ourselves and save/find as much cash as possible so we are ready to roll once the dust has settled. In my pursuit of stashing cash my question is, are there any issues with doing a HELOC on our primary resident (the same property that I did a cashout refi on a few months ago)? Are there pros and cons, penalties, tax implications, etc? I have been quoted by the big box lender who holds my note and they assured me that there was no issue but I wanted to circle back with the BP community for confirmation. Thanks again for the article, really helpful. (For context, we bought the property in 2018 for $300k, immediately renovated ($70k), it appraised for $415k, and we completed the cashout refi October 2019.)
    Anthony Williams
    Replied 4 months ago
    I would like to get a home equity loan to buy a hud property but none of the banks are willing to finance me because the property that I'm trying to refinance is a rental property and not my primary residence. I own the property out right. Do you have any advice?