What does cash out refinance mean?

Question

David Faulkner · Answer

After you buy and rehab, if you've done it correctly you will have created some extra equity in the property, above and beyond what you've invested in the down payment and rehab costs. You then could tap that extra equity by cash out refinancing, meaning that you pull some of the equity out in cash and refinance to a larger loan with a larger mortgage payment. The bank will not allow you to pull out all of the equity in the home ... you can usually get a loan on a rental for 75% of its market value (with 25% remaining in equity). Why would you want to do that? Because then you could get back out some, all, or possibly more than the original money you put in and go invest that money in another profitable deal. In the meantime, if you ran your numbers right and executed well the tenant now renting the property you just refinanced would be paying for the mortgage, all the expenses, and still leave you with a monthly profit with the monthly rental income. This is called positive cash flow ... be sure you understand and maintain it after the refinance.

Be aware that increasing the financial leverage by going with a larger loan magnifies your returns (even if those returns are negative). Many people in 2006 got over leveraged and when the economy and housing market got in trouble they got into financial trouble and got their homes foreclosed on, went bankrupt, etc. So leverage is great when it works but can be a nightmare if it doesn't ... all in all it can be a real benefit to investors who respect its power and are sensible about it ...

Chris Mason · Answer

A cash out refinance, like any other refinance, pays off your old loan using a new loan.

The significant difference with a *cash out* refinance is that the new loan amount is greater than the old old loan amount, but still less than current (post-appreciation/improvement/etc) value of the home.

The net proceeds go into your checking account as money you can spend.

You are now more in debt than you were before, but you liquidated some of that equity and (relevant in this forum) now you've got the down payment on your next home purchase.

Chris Sukala · Answer

@Crystal Perez well since we rehabbed this house everything is new all new appliances. New AC unit, roof, gutters. I just finished the bigger pockets book by Brandon Turner Rental Property Investing. You should  add a percentage for repair costs like new applainces, water heater, roof things of that nature so you have money to fix these unscheduled repairs.

Yes correct we originally purchased this house for 30k a small 2 bdrm/ 1 bath for cash and we completely remodeled it. Yes I would say we have 30% equity in it.

Hector Sapinoso · Answer

@Brent Coombs@David Faulknerthanks for clarifying the leverage question!

David Faulkner · Answer

Correct ... perhaps an illustrative example would help: Let's say you bought a house for $100,000 cash, and let's say that you happened to time the market very well (probably luck) and in one year the house went up in value to $110,000. You just made $10,000 on your $100,000.

Now, let's say you bought that same $100,000 house by putting $25,000 down and taking out a loan for the remaining $75,000. After the same year, you still make $10,000 but your initial investment was only $25,000. Because you were leveraged 4-to-1 your returns are also leveraged 4-to-1.

Let's look at the opposite scenario. Let's say your timing was really bad and that $100,000 house you bought went down in value to $90,000. If you were leveraged 4-to-1, your loss also gets leveraged 4-to-1. There are some safety nets in place if you engineered the investment properly, though. If the house is rented and produces positive cash flow, then you could just hold it and wait for the market to recover. Otherwise, since you put 25% down and the value went down 10%, even after 10% transaction fees you could still afford to sell at a loss ... you'd take a loss in that case, but the bank wouldn't have to foreclose on you. On the other hand, if you bought that house with only 3.5% down and it was producing negative cash flow, you'd be in the house of pain at that point with few exit strategies other than to foreclose or shell out money every month out of your paycheck if you were able ...

So, leverage can be very good or it can be very bad for you ... if you play things conservatively to guard yourself from the downside risk, then sensible leverage can be a very good tool for a skilled investor to utilize.

Brent Coombs · Answer

I believe David is referring to your Cash-on-Cash Return. Increased CoC gained by: increasing your leverage for the purpose of buying MORE income producing properties - without using any more of your OWN money! But, unless each property still cash flows positively despite of your extra mortgage, your NEGATIVE CoC returns are magnified too! Cheer up...

Crystal Perez · Answer

Sorry for the newbie question but what did you mean when you said you did not put in capital expenses?

Just so I understood correctly you bought all cash, rehabbed, waited a year, refinanced, and the bank gave you a check 70% of new appraised priced.

Now your currently 30% equity.

Hector Sapinoso · Answer

@Crystal Perezthanks for asking this, I've recently started listening to the podcasts and have been wondering about that myself.

@David Faulknerhow does increasing your leverage magnify your returns?

What does cash out refinance mean?

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