Decide whether it's a good idea to get a cash-out refinance on a primary home to buy an investment property.

Cash-Out Refinance To Buy an Investment Property: Should You?

Buying an investment property is a great plan for wealth creation and semi-passive income for your future.

So, can you get a cash-out refinance on your primary home and use the funds for a down payment on an investment/rental property?

Yes, you can. Here’s how to do that, as well as some insights on whether it’s a good idea.

Step 1: Make sure you have enough equity

Make sure you have enough equity in your home. To get the best rates, you’ll want:

  • Maximum 75% loan-to-value (LTV) on your primary home after the cash is taken out
  • Maximum 75% LTV (25% down) on the new rental property

Here’s an example.

Primary home value$500,000
Max new loan$375,000
Current loan balance-$250,000
Closing costs-$7,000
Cash out$118,000
Max rental property price (Cash received divided by 0.25)$472,000

In this example, you would have 25% equity left in your home and be able to put down 25% on the new property. 

You can go up to 80% loan-to-value on the cash-out loan and the rental property loan according to Fannie Mae rules. But rates really start to skyrocket. Also, a 680+ score to help keep your rates low.

Step 2: Figure out how much the cash will cost you

Rates are likely higher than when you received your primary residence mortgage. If you go from 4% to 7% while increasing your loan balance, your payment can rise dramatically.

Make sure the cash is worth it. Here’s an example, assuming you need $75,000 cash for the new rental property plus $7,000 in closing costs.

Loan amountInterest rateMonthly payment
Current loan$250,0004%$1,194
Cash-out loan$332,0007%*$2,209
Additional monthly cost$1,015

Step 3: Determine rental property cash flow & ROI

Make sure the property will produce enough cash to justify the extra expense on your primary home.

This isn’t as straightforward as it seems. I recommend Bigger Pockets rental property calculator to determine how much profit the property will produce. The calculator factors in things like loan payment, vacancy, repairs, and other costs.

It’s tempting to use rent income minus the payment to arrive at monthly profit. But as someone who owns two rental properties (one of which is pictured above), I can say that this isn’t your true profit.

Here’s a simplified example of rental property cash flow assuming a $300,000 rental property purchase.

Rental property price$300,000
Down payment (25%)$75,000
Final loan$225,000
P&I payment at 7.5%*$1,573
Tax, insurance$300
Vacancy, repairs, management$500
Total rental property monthly cost$2,373
Rental income$2,500
Profit+$127

Even with high gross rental income, the property still only cash flows $127 per month, not enough to justify incurring a primary home payment of more that increased more than $1,000. 

But run your own numbers. Maybe your scenario makes more sense than my example. This might be the case if:

  • Your primary home interest rate stays about the same or drops with the refi
  • You’re planning to flip the property, not rent it out
  • The rental property purchase price point is a lot lower
  • You’re getting the property below market due to needed repairs
  • You’re buying a short-term rental where monthly rental income is much higher

Come to your own conclusion, but hopefully this example shows the factors you should consider.

Step 4a: Decide if a home equity line or loan is better than cash-out

If you have a very low rate on your primary residence currently, say 3-4%, consider a home equity line of credit (HELOC) or home equity loan.

Either of these loans sit on top of your current first mortgage. You don’t have to take a higher rate on your primary mortgage to get a large amount of funds.

And home equity lines and loans come with much lower closing costs than a full cash-out refi.

If you only need $25,000-$75,000, a HELOC is likely better, depending on your current first mortgage balance and rate.

Cash-out refinanceExisting loan + HELOCExisting loan + home equity loan
1st mortgage$332,000 @ 7%*$250,000 @ 4%$250,000 @ 4%
1st mortgage payment$2,209$1,194$1,194
$75k 2nd mortgage (8%)*N/A$500 (interest-only)$627 (fully-amortizing 20-year loan)
Total P&I payment$2,209$1,694$1,821

In this case, it’s probably better to leave your first mortgage alone and get a HELOC or home equity loan. Unless rates drop significantly from current levels (7-7.5% in late 2022), a 2nd mortgage will likely pencil out better.

Step 4b: Get the cash-out refinance on your primary home

If you’ve determined that taking cash out to buy an investment property makes sense, the next step is to get the cash-out refinance on your home.

Getting a cash-out refinance is similar to a regular refinance. The major difference is that you are taking a bigger loan than what you owe. At closing, escrow wires you the overage after paying off your existing loan and covering closing costs.

Here’s the basic process

  • Shop around for a lender to ensure you’re getting the best rate and fee structure
  • Apply for the loan
  • Submit your paystubs, W2s, tax returns, bank statements, and anything else the lender asks for
  • Once approved, the lender will send final loan documents to escrow
  • Sign final paperwork
  • The loan closes and escrow wires you cash-out funds

About a cash-out letter of explanation

The lender may ask for a letter of explanation for the cash-out funds. 

Fannie Mae states that you can use cash-out funds for any purpose. However, the lender has the right to ask what the funds are for. 

If it does, here’s a sample/template letter of explanation for a cash-out refinance.

Don’t volunteer the information if not asked. The lender may want to know the terms of the future loan and rental income. Then you have a real chicken-and-egg problem. You need the cash to buy a property, but you can’t get the cash until you have final rental property loan terms.

If this happens to you, see if the underwriter will accept estimated terms. Ask your loan officer about other ways to get the cash-out loan completed before you buy the property.

Step 5: Apply for the investment property loan

Next, you’ll get a pre-approval so you can make an offer on an investment property.

It’s a good idea to get full pre-approval by submitting all your documentation. If you apply with the same lender, your loan officer may be able to use some of the same paperwork you submitted for the cash-out loan.

Applying to buy a rental property is similar to buying a primary home, with a few differences:

Reserves

If you have other financed investment properties, you may have to prove reserves. Reserves are extra funds in the bank after closing. Here’s what Fannie Mae requires.

  • 2% of unpaid balances if 1-4 properties owned
  • 4% of unpaid balances if 5-6 properties owned
  • 6% of unpaid balances if 7-10 properties owned

Your primary home and the rental home you’re buying don’t count toward financed properties owned.

Using future rental income to qualify

Fannie Mae allows you to use future rental income to qualify. Market rent is reported by the appraiser on Fannie Mae form 1007 or current lease agreements if the property is already rented. The lender should request the 1007 along with the appraisal.

Step 6: Buy the investment property, find a tenant

The final step is to use your pre-approval to find an investment property. 

Make an offer and complete the loan process. You are now a landlord.

Find a great tenant or market the home as a short-term rental. 

With great management, the property will yield income for years to come.

Cash-out refinance to purchase a rental property: FAQ

Are cash out funds for an investment property tax deductible?

No. IRS rules state that only the portion of the mortgage balance used to purchase or improve your primary home is tax deductible.

Should I take out a HELOC to buy an investment property?

This could be a better idea than replacing a low-rate primary mortgage. A HELOC does not affect your first mortgage, so you keep your low rate. However, a HELOC comes with a variable rate, potentially meaning higher payments in the future. Consider a home equity loan, which comes with a fixed rate.

What are current rates on a cash-out refinance?

All mortgage rates are currently relatively high compared to the last ten years. That’s why it’s important to determine whether the cash is worth the higher rate you’ll be taking on. A cash-out refinance requires you replace your first mortgage, at which point you lose your current low rate.

Get started on your cash-out refinance or HELOC to buy an investment property

Buying an investment property is one of the best moves you can make to secure future semi-passive income and equity appreciation.

If a cash-out refi pencils out, it’s a great way to raise funds for the down payment on a rental.

*Rates and payments are for example purposes only. Your costs will be different.

Author

  • Tim Lucas

    Tim Lucas spent 11 years in the mortgage industry helping hundreds of mortgage clients from all walks of life, from first-time buyers to those buying multi-million dollar homes. He purchased his first home at 26 with just $1,100 out-of-pocket and now owns real estate worth $2.4 million. Tim was the managing editor at national websites TheMortgageReports.com, MyMortgageInsider.com, and Home.com. He combines hands-on experience with his editing background to bring unfiltered truth about mortgage topics. Tim has been featured in publications such as Time, U.S. News, MSN, and more. Connect with Tim on LinkedIn and Twitter.

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