Homeowners have the opportunity to borrow against the equity in their homes by taking out a home equity loan or home equity line of credit (HELOC).
Home equity is the difference between the current market value of your home and the outstanding balance on your mortgage. You can use the proceeds from your home equity loan or home equity line of credit in any way you want—including on an investment or rental property.
This might sound great. But before you use your home equity on an investment property, it’s important to understand the details of the loan and any potential risks you may face.
The Differences Between Home Equity Loans and HELOCs
A home equity loan provides the borrower with a lump sum at closing based on the total amount of equity in the home. The borrower pays off the loan in fixed monthly payments over a period of 10 to 15 years.
A home equity line of credit is similar to a home equity loan because the maximum amount of credit extended to the borrower is dependent upon the total equity that the borrower has in the home. Unlike the home equity loan, however, the HELOC allows the borrower to use only the amount of credit needed.
The borrower can also continue to use the credit over and over again as it gets paid off. So, the funds are not available for one single use as they are with a home equity loan. While there are pros and cons, a home equity loan or HELOC can be a good way to purchase an investment property because the application process may be easier.
A home equity loan or HELOC can also be a good source of cash to make repairs or improvements on an investment property because the interest rates are much more favorable than other forms of borrowing, like credit cards and personal loans.
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Home Equity Loan & HELOC Tax Benefits
Prior to 2018, federal tax law allowed homeowners to deduct the interest they paid on their mortgage as well as their home equity loan or HELOC. At the beginning of 2018, however, the IRS added some qualifications to home equity debt tax deductions.
Under the current law, interest on home equity debt is only tax deductible if the homeowner uses the proceeds to make substantial improvements to the property serving as collateral for the loan. As a result, homeowners cannot deduct the interest if they use the proceeds to purchase or improve a separate investment property.
Are Home Equity Loans & HELOCs Good for Investment or Rental Properties?
Don’t make the mistake of assuming that all real estate is a good investment. Compared to other investments, owning real estate is capitally intensive and has high transaction costs. It’s important to do a lot of research before investing in a property.
The return you’ll be able to generate depends on the equity you invest in the property, financing costs, taxes and insurance, maintenance and repair expenses, rental income, and appreciation rates. A good investment property has the potential to earn a 4 percent to 10 percent annual return.
In this case, the investment would be a good use of your home equity. On the other hand, a poor investment choice could depreciate in value, experience long periods of vacancy and below-market rental rates, and end up as a net loss. Research can be the difference between making money and losing money in a real estate investment.
Risks to Understand
The biggest risk associated with using a home equity loan or HELOC is that your home serves as the collateral for the debt. While this is what allows you to borrow such a substantial amount of money at such a low interest rate, it is also what can cause a tremendously large loss if things go wrong.
If you can no longer make the payments on the home equity loan or HELOC, the lender will foreclose on the collateral property in order to fulfill your debt obligation. In this case, that is your primary residence. So not being able to make the payments on the debt you used to finance your investment property will cause you to lose your home.
Since the investment property does not serve as the collateral, that property may not be impacted by these financial difficulties. You would only face foreclosure on the investment property if you also have a mortgage on that property that you cannot pay.
In the end, you need to decide if you are willing to risk losing your home for your investment property. If it is a relatively high-risk investment property, you might be safer to consider another source of financing or finding a safer investment for your home equity.
Interested in how much you could get from a home equity loan? Use our home equity loan calculator to find out.