Homebuyers

Investors: How to Make Your Current Rental Property Pay for Your Next One

Real estate investors who already own one or two rental properties may be sitting on a financial opportunity they might not have realized.

If you financed your current properties with a Debt Service Coverage Ratio loan, also known as a DSCR loan, a cash-out refinance could give you the funds to expand your real estate portfolio without going through a lengthy loan approval process.

The strategy is straightforward. With a cash-out refinance, you typically replace your existing mortgage with a new, larger one and then pocket the difference. So, you refinance the mortgage on your existing rental property, pull out equity in the form of cash, and use that money as a down payment on your next investment property.

DSCR loans are tailored for investors because they focus on the income potential of the properties instead of your personal income. Investors may be able to secure a cash-out refinance for one of these loans even if they don’t have a high credit score.

“There is no income verification,” said Diana Pollard, a New American Funding loan officer based in Charlotte, N.C. “The loan is based on the appraisal and potential rental income of the property you’re financing.”

That makes these refinances particularly valuable for investors whose rental income is strong, but whose personal tax returns might not show the income needed for traditional financing. The property does the talking.

Let’s look at how a cash-out refinance on a DSCR loan may be able to help you purchase additional investment properties.

What are the benefits of a DSCR cash-out refinance?

Savvy investors know that DSCR loans enable smaller investors to get into the real estate game, even if they don’t have a high-paying job and a stellar credit score. That’s because DSCR loans are made based on the projected profitability of the property.

To figure out the debt service coverage ratio of an investment property, lenders look at how much money the property is expected to generate a month. This number is divided by the total monthly mortgage payment, which includes the principal, interest, taxes, and insurance.

Lenders want to see answers to that equation that are at least 1.25 or higher.

Although DSCR loans don’t require personal income verification, they typically require a larger down payment than a mortgage for a home you plan to live in. A 20% down payment is typically the minimum required as well as several months of cash reserves.

Investors who do a cash-out refinance on a DSCR loan may need to put down up to 50% of their equity if their credit scores are lower.

“The proceeds [from the refinance] can be used to purchase a new property (including making a cash offer), fund renovations or a flip project, or pay off existing debt,” said Pollard.

Since investment properties are often in high demand, having the ability to make a cash offer or a larger down payment might be the difference between landing your next flip or losing it to a competitor with deeper pockets.

You will need a credit check for a DSCR cash-out refinance. Some lenders may request a list of other investment properties owned, but those properties are not used for verification purposes, and full documentation is not required.

What are the risks of DSCR cash-out refinances?

A drawback of doing a cash-out refinance of a DSCR loan is potential prepayment penalties.

DSCR loans are typically available for 15-, 20-, and 30-year terms. But if you refinance the loan or sell the property earlier, you may be subject to these penalties. And loans without these penalties may have a higher interest rate.

However, freeing up that cash to buy new properties and the opportunity to lock in a lower mortgage interest rate, if rates fall, may offset the fees enough to make it worth it.

That makes using your existing properties to help you expand your real estate portfolio something you may want to consider.