This Surprising Financial Maneuver Can Help You Buy a Second Home

Investing is about giving up a little bit now in order to get a lot back later. If you consistently contribute a modest amount of money to something over a long enough period, you can expect to see your investments grow to an impressive size.

But when it comes to investing in real estate, you’re expected to give up more than a little in order to get started, which can be intimidating for new investors. It’s difficult to come up with the initial funding (a down payment), and committing such a large amount to a property can be disastrous if the investment doesn’t work out.

That’s where a cash-out refinance comes in handy. Here’s what you need to know about using one to buy another property if you’re already a homeowner.

A cash-out refinance is when you refinance your mortgage with a new loan that’s greater than your current loan balance. You can only complete a cash-out refinance if the current value of your home is much greater than the remaining balance on your mortgage. For example, you’d be a good candidate for a cash-out refinance if your home is worth $300,000 and the remaining mortgage balance is $100,000.

Lenders will only let you withdraw up to 80 percent of the home’s current value, minus the remaining balance. In this example, you could receive up to $140,000 when you complete a cash-out refinance.

You could then use the $140,000 as a down payment on your next property. Like with a regular refinance loan, you still have to qualify for a cash-out refinance. Lenders usually require a credit score of 620 or higher and a debt-to-income (DTI) ratio of 50 percent or less.

If you plan to use the proceeds from the cash-out refinance to buy an investment property, you’ll need to put down between 15 percent to 25 percent. If you’re buying a primary residence, then a smaller down payment is acceptable. Lenders don’t care if you use proceeds from a cash-out refinance for the down payment.

When you apply for a cash-out refinance, you can choose between a fixed-rate or variable-rate loan. The latter will mean payments can increase if the interest rate goes up. 

When you complete a cash-out refinance, the interest rate on the new loan may be higher than your original interest rate. This means you may end up paying more interest overall through the life of the loan. Before taking out a cash-out refinance, do the math and figure out if buying another property will make up for any extra interest you’d pay. And keep in mind that by opting for a cash-out refinance, you’re extending the repayment period of your existing debt—for many years to come. It’s not the right decision for everyone.

Like any other kind of refinance loan, you’ll have to pay closing costs, which range from 2 percent to 5 percent of the new mortgage. These will be deducted from the cash payout, as there’s no way to roll them into the mortgage. And as with a regular refinance, make sure to find the best offer and apply with a few different lenders. Search for a lender with the lowest closing costs—some may even offer a discount.

Instead of completing a cash-out refinance, you can also take out a home equity loan against your house. 

A home equity loan doesn’t have any closing costs, and may be less expensive than a cash-out refinance if your current mortgage has an interest rate lower than what you would qualify for currently. If you don’t need to withdraw a large sum of money, then a home equity loan may be a better option.