Refinancing Into a Long Term Mortgage

This post is one in a series of articles discussing owning and operating single family rental houses in the Dallas, Fort Worth, Denton area. We talk about buying foreclosures or HUD homes, fixing them up and then renting to qualified tenants. If you are new to this blog, please read “Getting a Mentor” and “Getting Started“. You can follow the series from there.

In this post we’ll dive into the details of refinancing into a long term mortgage. Note that we talked about getting a bank or a loan provider to finance your initial purchase, closing costs and rehab costs in an earlier post. If you have done that you probably have a higher interest, short term loan. After you have leased your property to a qualified tenant, you now want to obtain long term lower interest financing.

Before we talk about the different refinancing options, let’s look at your current position with respect to this particular property. The options are:

  1. You purchased this with a conventional loan and have about 20% of pre-rehab value in it is as your equity (down payment). On top of that you have your own money invested in it for rehab.
  2. You purchased this with cash and used your own money for closing and rehab costs.
  3. You financed the purchase, rehab and closing costs and have just marketing and carrying costs as out of pocket expenses so far.

What kind of refinancing you want to do depends on what route you took to get to this point. If you went with option 1, above, then most likely you are already set. You have a rather large investment in this particular property with 20% down plus closing plus rehab costs, about 35% of purchase price and about a 65% loan. For a $100K property that’s $35,000 out of pocket. The obvious negative with this approach as we have discussed before is that it limits how many properties you can do, assuming your liquid funds set aside for real estate investment are limited. The positive is that your loan amount at $65K is low enough that you can enjoy a good cash flow every month. Another positive is, with a single loan approach, you only incur one set of closing costs.

If you used option 2, then you are rather heavily invested with your own money in just this one property. In order to obtain more properties you may need to pull some equity out. So what you do is a cash-out refinance. “Re-fi” is rather a misnomer here as you don’t have a loan on it to begin with but the method is the same as if you had one. You are just converting built in equity into liquid cash. You may be able to pull out as much as 75% of the property’s after repair value. Allocating about 5% for closing costs, you may have as cash when all’s done about 70%. The difference from option 1 is that your mortgage may not be that low given that it is 75% of after repair value not purchase price. So with a purchase price of $100K and an after repair value of $150K, your loan amount is $112,500. So your monthly mortgage payment would be high and cash flow considerably lower than option 1. You have the same advantage of just one set of closing costs.

With option 3, your current position is that you have a loan that covered your purchase price, closing costs and rehab. However, this loan is a high interest, short term loan. You do not have any of your own funds invested in the property. You may have had some marketing and carrying expenses, however those are expenses not equity in your property. With this option, the refinance that you want is called rate-term refinance. The second lender will pay off the first and provide you with new terms on the owed amount. This typically is a 15 or 30 year loan with a lower fixed interest rate. The loan amount will be somewhat close to what we had in option 2. So, the monthly cash flow will be lower compared to option 1.  You have had two loans, so you incur two sets of closing costs. True expenses will be higher with this route. However, you get into an income producing asset with none of your liquid cash invested in the property.

One key point to note about option 3 is that the max value of the loan amount is normally about 75% of the after repair value. If the payoff amount for the first loan, which includes the original purchase price, first closing costs, rehab costs and interest till second loan pays it off, is greater than 75% of after repair value, that difference you will have to bring to closing. This is a one key point to keep in mind when getting into that deal in the first place: Make sure your total liability on the deal is less than 75% of after repair market value. It’s important that your mentor/agent goes over this with you.

As we talk about conservative investing in these posts, it’s important to point out a key risk with option 3. With this option, till you secure that second long term financing, you must realize that you are carrying a rather high risk position. You are in a short term, high interest loan for somewhere around $100K. If for any reason you are unable to secure that second loan, you will have to pay the entire amount plus interest at maturity with your own funds. So know your ability to secure long term financing well. This includes your job position: income stability, likelihood of losing your current job; credit rating: score, late payments, foreclosures etc. Again, it’s key to discuss this matter with your mentor/agent and get proper guidance.

We have mentioned after repair value a few times in this post. The question is, who establishes that? Well, for most loans, especially the long term conventional ones, the lender will need to see an appraisal done by a licensed real estate appraiser. Your idea of market value and an appraiser’s could be rather different. So be prepared for that. Estimate your value as conservatively as you can. Many real estate investors and home buyers as such are going through appraisal shock as may appraisers are coming up with values far below the expectations of other parties in the transaction. If the borrower is not prepared for this, these appraisals will kill the deal. These so called “low ball appraisals” need a closer look which I will do in my next post.

About Bernie

Bernie is a distinguished technologist (Motorola heritage). He along with his wife invest in residential real estate in north and central Texas. Bernie loves to teach, both technology and real estate investing and so authors posts on this blog. You can reach Bernie at
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