Cash Out Refinancing Overview
One of the best ways to build significant wealth is through periodic cash out refinancing of real estate. Equity builds in a property as it appreciates and as the mortgage debt is paid down. An investor can take some of this equity out as cash by refinancing the property. The property will then have a new loan and the process begins all over again.
Cash out refinancing also allows investors to recycle their initial down payment to purchase additional properties. This strategy takes years but is highly effective and relatively low risk. The example below follows Charlie as he uses a down payment of $25,000 and a series of refinancing to create $1 million in net worth.
First $25,000 Down Payment
Charlie gets serious about creating wealth and sells his car and motorcycle. He uses the $25,000 in proceeds as the down payment on his first property.
First Property:
Charlie purchases a two-bedroom property for $125,000 with a $25,000 down payment and a loan of $100,000. Charlie moves into the property and rents the second bedroom for $550. The rent covers most of his mortgage payment and lowers his living expenses allowing him to save more money each month.
Net Worth After First Property:
Real Estate Value: $125,000
Debt: -$100,000
Net Worth: $25,000
Second Property:
After a few years Charlie’s property appreciates to $200,000. Charlie made extra mortgage payments during these years paying off $25,000 of his loan. His mortgage debt declines to $75,000. He then refinances the property, pulling out $50,000 in cash and starts a new loan of $125,000.
Charlie pulled out his initial $25,000 down payment and the $25,000 in mortgage payments by withdrawing $50,000 in cash. Charlie still owns the property but has none of his own money invested in this property.
There is an added benefit from refinancing. The interest rate of Charlie’s original mortgage was 7%. But mortgage rates declined to 5% when he refinanced saving him 2% each year in interest on his mortgage.
Charlie uses the $50,000 from refinancing as the down payment on his next property. He buys the property for $250,000. He rents the new property, using all the rental income to pay expenses and the mortgage. He uses any profits to pay down the mortgage which helps Charlie continue to build equity and reduce his debt.
Net Worth After Second Property:
Real Estate Value: $450,000
Debt: -$325,000
Net Worth: $125,000
Third and Fourth Properties:
After a few more years, the first property is worth $300,000 and the loan balance is $100,000. Charlie refinances the first property again to pull out $100,000 in cash. He has a new loan of $200,000 and retains $100,000 in equity in the first property.
Charlie’s second property has increased in value from $250,000 to $300,000 adding $50,000 in appreciation. He has also paid down the loan to $200,000. His equity in the second property is now $100,000. Charlie continues to rent the two properties and uses the profits to pay down the mortgages.
Charlie identifies an up-and-coming neighborhood where he thinks prices will increase in the coming years. Charlie uses the $100,000 from refinancing to purchase two more properties for $250,000 each. He makes a $50,000 down payment on each property and finances the rest. He has a total of $100,000 in equity in the two new properties and a loan balance of $400,000.
Net Worth After Third and Fourth Properties:
Real Estate Value: $1.1 million
Debt: -$800,000
Net Worth: $300,000
Fifth Property:
After a few more years Charlie’s first property is now worth $400,000 and his loan balance is $150,000. He refinances this property for a third time, pulling out $100,000 in cash. His new loan is $250,000 and he has $150,000 of equity in the property.
His second property is worth $350,000 and the loan has been paid down to $150,000. He has $200,000 in equity in this property. Charlie's third and fourth properties are now both worth $300,000 and he paid down each loan by $50,000. He owes $100,000 on each of the two properties and has $200,000 in equity in each.
Charlie uses the $100,000 in cash from refinancing to purchases a property for $500,000. This is a multi-family property with three units. Charlie again uses all the profits from the rent to pay down the mortgage at a faster rate. Charlie has yet to take any profits from his properties, he remains focused on building equity and paying down debt.
Net Worth After Fifth Property:
Real Estate Value: $1.850 million
Debt: -$1 million
Net Worth: $850,000
Sixth Property:
After a few more years, Charlie refinanced his first property a fourth time. It is now worth $425,000 and his loan balance is $200,000. He pulls out $100,000 in cash and takes a new loan of $300,000. He uses the $100,000 as a down payment on a duplex. The duplex costs $500,000 and his loan on this property is $400,000. He finds tenants for both sides of this duplex.
His second property is now worth $375,000 and the loan is paid down to $100,000. His third and fourth properties are worth $325,000 each and he owes $75,000 on each one. Charlie’s fifth property is now worth $600,000 with a loan balance of $400,000. Charlie has hit his goal of being a real estate millionaire. He did it with a single $25,000 down payment that was strategically recycled to buy the rest of his properties.
Net Worth After Sixth Property:
Real Estate Value: $2.55 million
Debt: -$1.35 million
Net Worth: $1.2 million
Lessons from Cash Out Refinancing
The strategy Charlie used is fully replicable. Charlie reduced his living expenses by having a roommate and made lifestyle concessions by selling his vehicles to save for a down payment. Also, having good credit ensures Charlie is able to get the lowest mortgage rates, which reduces borrowing costs.
Charlie could have refinanced his other properties to acquire more properties at a faster rate, but doing so would increase his debt levels. He did not want to be at risk if there was a period of severe rental vacancies. His investment style is more conservative and he is happy with the results. An investment strategy should always match your temperament, to prevent your investments from keeping you up at night.
Achieving Financial Freedom
Now that Charlie hit his financial goal he no longer has a roommate and is looking to enjoy some of the profits from his rentals. If he stops investing now, he will have eight rental checks coming in every month. In a few years he will pay off all his mortgages, dramatically increasing his rental profits. Charlie plans to set aside 50% of his rents to pay for real estate expenses like property taxes, insurance, repairs, vacancies and capital improvements. The remaining rental profits cover his living expenses. For $25,000 and several years of investing in real estate, Charlie has achieved financial freedom.
To make your plan for financial freedom see the book Become Loaded for Life and the 10 Stages Workbook.
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