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| Refinance - a way to convert Real Estate equity to cash |
Real Estate isn't very liquid type of investment. This means that you can't easily convert the value of your real estate properties into cash and go buy some groceries. This value is called equity.
Equity equals to current market price of your property minus the mortgage / loan balance that you have against the property.
As you hold a property, equity grows as market prices go up and as your mortgage principal is paid down by your tenants. If market drops, equity drops as well.
There are several conversion mechanisms to convert equity to cash. Re-financing is one of them. Another method is selling the property.
When you re-finance a property, you are basically starting over with a new mortgage.
As a result, your monthly mortgage payment will change. In my case, it went up considerably because interest rate has gone up from 2.95% to 4.39% and also because the size of the new mortgage is a lot higher than previous mortgage balance.
It might seem on first glance that re-financing and getting a higher monthly mortgage may be a very bad thing. If you think about it, your level of debt goes up. Your interest costs go up. Your cash flow from the property goes down. There are also various costs associated with the refinance transaction including mortgage broker fees, lender fees, and lawyer fees. Why would you do it?!?
Here are the reasons why this worked for me:
1) Getting Your Money Back
Several years ago, when I originally purchased the property, I put in some money as a down payment. After purchase, I invested some additional money to renovate the place.
Refinancing helps me get all of my money back.
Once you have your money back, you can use it however you please. You can put it as a down payment for another asset, for instance. Or maybe you are nearing retirement age and would like to spend the money on your day-to-day expenses. Or perhaps, you have higher interest debt and you could use the money to pay off the lenders.
2) Maximizing Return on Investment
Let's take a look at an example. Suppose you buy a property for $100,000 with $20,000 down payment and suppose the market goes up by 2% every year. Let's also say that principal pay down is negligible, for simplicity of calculations.
Then, after the first year, the property will appreciate to $102,000 and you would've gained $2,000.
Return on Investment (ROI) = $2,000 / $100,000 = 10%.
In this example, the market went up by 2%, but you made 10%.
This is because even though you provided only 1/5th of the money (20% down payment), you benefited from the growth of the entire house - and you got all of the gain.
What if you re-finance and pull all of your investment money out? In that case, you no longer have any of your money in the property, yet again you benefit from the appreciation of the entire house. This is when you get maximum returns:
Return on Investment (ROI) = $2,000 / almost nothing = Infinity!
3) Doubling # of Assets That Work for You
Suppose, you buy another asset using the money that you pulled out at refinance.
Now, you have two assets working for you. Together, the gain from appreciation is $2,000 + $2,000 = $4,000.
Here are sample numbers for a refinance transaction:
The numbers above show you key numbers behind a refinance transaction. In this example;
New lender approved a loan of 255K. Out of this loan, previous mortgage of 135.5K was paid. Almost 7K was paid in fees.
Investors got all of their money back.
There was 63.7K of cash pulled out of equity. This is ~ 115% return on investment since the start of the project. Or, 29% annualized ROI.
Note: mortgage debt increased from 135.5K to 255K.
If you have any questions or would like more info, please comment below or contact me.
PS It might be tricky to figure out how much equity you've got in your property. Here's an Excel tool that I use to do all my numbers when it comes to planning mortgage pay down and future refinance transactions to extract equity.
