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You can use the proceeds from your home equity loan or home equity line of credit (HELOC) in any way you want—including on an investment or rental property.
Using your home equity to put a down payment on or purchase an investment property is possible, and is often one of the cheapest borrowing options you may have.
If you already have equity built up in a rental property, you may also be able to take out a home equity loan or HELOC against that equity. Just note that you may be eligible for less money than you would be with your primary home.
This article will focus on the first situation.
On this page:
- Using Home Equity for an Investment/Rental Property
- Advantages of Using Home Equity on an Investment Property
- Risks of Using Home Equity for Investment Properties
- Choosing Between Home Equity Loans & HELOCs
- Home Equity Loan & HELOC Tax Benefits
- Alternative Financing Options for Investment Properties
Using Home Equity for Investment or Rental Properties
Using your home equity to make a down payment or to fully purchase a rental property may be a good idea because it can help you secure low rates without having to go through the process of getting a second mortgage.
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 usually much lower than other forms of borrowing, like credit cards and personal loans.
Most lenders will have a maximum combined loan-to-value ratio (LTV) of around 85%. This means that your mortgage and home equity loan can’t exceed 85% of your home’s current value.
For example, if your home is currently worth $200,000 and you have a mortgage balance of $120,000, your current loan-to-value ratio would be 60%. The maximum amount of debt you could have—including your mortgage and home equity loan—is $170,000 (85% of $200,000). This means the total amount of a home equity loan you could receive is $50,000 ($170,000 – $120,000).
>> Read More: Using a Home Equity Loan to Buy Another House
Advantages of Using Home Equity on an Investment Property
Using funds from a home equity loan or HELOC is often a smart money move for many consumers. Here are some of the key advantages of doing so:
- Low interest rates. As compared to unsecured forms of debt, such as personal loans, home equity loans and HELOCs have low interest rates, making this an inexpensive form of borrowing.
- Utilize the equity you’ve built. Though you may not realize it, your home equity is a part of your net worth. It is, however, much harder to get your home equity to work for you like you can with savings and investments. With a home equity loan or HELOC, you can utilize your equity to grow your money.
Risks of Using Home Equity on a Rental Property
As with any financial product, there are some risks to consider when using a home equity loan or HELOC on an investment property.
- Primary residence acts as collateral. If you can no longer make 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.
- Closing costs & fees. You will have to pay closing costs and fees on your home equity loan or HELOC. While these aren’t typically as high as closing costs on mortgages, other loan options—such as personal loans—often don’t have any fees.
Choosing Between Home Equity Loans and HELOCs
Home equity loans come in a lump sum and have fixed interest rates that are repaid in monthly payments over a set period of time of usually 10 to 15 years. The total amount you can borrow is based on the amount of equity you’ve built in your home.
A HELOC is similar to a home equity loan because the maximum amount of credit extended to you is dependent upon the total equity you’ve built. Unlike the home equity loan, however, a HELOC is a line of credit that you can draw on multiple times during the draw period. HELOCs also have variable interest rates that fluctuate with the market.
If you think you just need the loan for a single expense, such as a downpayment on your investment property, then a home equity loan may the better choice because of the fixed rates and predictable repayment. If you want an ongoing line of credit that can be used on future expenses, go with a HELOC.
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.
Alternative Financing Options for Investment Properties
While home equity loans and HELOCs make great choices for funding investment or rental properties, there are some alternatives you may want to consider.
If you need more money than you can get through a HELOC or home equity loan, you may want to consider taking out a second mortgage for your new property.
The main advantage of taking out a new mortgage for your investment property is that your current home won’t be at risk if you can’t make payments. In addition, you may be able to get a larger loan amount than you would with a home equity loan or HELOC.
However, second mortgages are more difficult to qualify for, have higher interest rates than you would get on a primary residence, and you will still have to pay closing costs which can be expensive.
>> Read More: Second Mortgage vs. Home Equity Loan
Another viable alternative is refinancing your first mortgage for more than you currently owe and taking the extra amount as a lump sum. This is called a cash-out refinance.
For example, if you owe $100,000 on your primary mortgage, you could refinance it to $200,000 and receive $100,000 as a lump sum to invest in your rental property.
The main benefit of using a cash-out refinance is that you should be able to secure lower rates than you would with a home equity loan or HELOC. In addition, interest is tax deductible for cash-out refinance loans up to $750,000, unlike home equity loans or HELOCs (unless used for home improvements).
Like a second mortgage, you will have to pay closing costs on your cash-out refinance. In addition, if the cash-out refinance rate you qualify for is higher than your current mortgage rate, it may not make sense.
>> Read More: Cash-Out Refinance vs. Home Equity Loan
Author: Kimberly Goodwin, PhD