While some challenges may come with securing a home equity line of credit (HELOC), the benefits are often worth investing time and resources. Using a HELOC on investment property will allow investors to tap into assets that have managed to build up equity. Likewise, investors can take advantage of otherwise stagnant equity. It can be thought of as an alternative funding source to do any number of things: upgrade your home, boost your credit, consolidate debt, or even buy a new property. At the very least, understanding how to use a HELOC for investment property is crucial for anyone who wants to gain a competitive edge.
What Is A Home Equity Line Of Credit (HELOC)?
A home equity line of credit is a homeowner loan with a maximum draw, instead of a fixed dollar amount backed by the lendee’s equity in their home (similar to a second mortgage). A HELOC is a lender’s promise to advance the lendee up to the set amount at the time of their choosing instead of a regular mortgage that is typically paid out in full at closing.
Most HELOCs have set “draw” periods where the borrower must use the credit and then another period to repay the loan. Borrowers are typically given five to 10 years where they are required only to pay interest, while repayment periods are typically 10 to 20 years. Lines of credit borrowed against a home can be an invaluable resource, which begs the question: Can I take a HELOC on an investment property? Or, if you are already convinced this is the way to go, what banks offer HELOC on an investment property?
To be clear, investors can take out a HELOC on their investment property. However, there are many things they should know before doing so. As for the banks willing to do so, investors will need to shop around. While not every bank will allow owners to take out lines of credit on their rental properties, there are plenty out there who will; the rick is to shop around much like a regular loan.
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How Do You Use A HELOC On Rental Property
Can you get a home equity line on a rental property? The answer is simple: yes. Using a HELOC on investment property can become an invaluable source of alternative financing as soon as investors build up enough equity in an asset. When managed correctly, a rental property HELOC can turn into an ideal wealth-building strategy for savvy investors.
For one, investors can borrow money against the equity in one rental property to fund the purchase of another. A HELOC can also be used to fund home improvements for their rental properties, just as a homeowner would for their primary residence. Smart investors will even get a HELOC on their primary residences to pay off mortgages on their investment properties or even any high-interest debts.
There are several challenges investors must overcome to successfully use a HELOC on rental properties. For starters, banks are less inclined to lend on investment properties, as owners are more likely to default on homes that aren’t a primary residence. Thus, the incentive to stay current on a primary home is less apparent in investors with rental properties. It may also be difficult for investors to even qualify for a HELOC. Lenders look at the debt-to-income ratio, credit score, other open accounts, and lendee’s available cash cushion. Even if you have available cash flow, it doesn’t necessarily make you the right candidate.
Do note that investors (and homeowners) who choose to pursue the HELOC route may find it easier and more feasible to qualify for a line of credit on a primary residence.
Can You Use A HELOC For A Down Payment On An Investment Property?
A HELOC can be used to buy an investment property. In fact, if you are going to use a HELOC on anything, you might as well put it into a sound investment. Unleveraged equity is, after all, dead money that could end up costing you in the long run. Thanks largely, in part, to inflation, stagnant equity that isn’t making any interest or return on investment (ROI) is essentially throwing money away. That said, using equity to buy an investment property with a sound game plan is almost always preferred to using equity for anything else. Since a HELOC will use the home as collateral, it’s important to make sure the loan is worthwhile.
Home Equity Loan Vs HELOC
Home equity loans offer borrowers a lump sum of capital that the bank will expect to be repaid over a predetermined period of time. Using a HELOC on investment property is essentially a revolving line of credit that can be tapped into whenever the borrower likes.
At a glance, home equity loans (HELs) and HELOCs appear to have a lot in common. The similarities in their names alone are enough to confuse anyone unfamiliar with their uses. However, it is worth noting that their similarities are only “skin deep.” There are several differences between HELs, and HELOCs investors need to know about before they acquire one over the other.
For starters, the interest rates on each are different. Traditional home equity loans tend to have a fixed interest rate. On the other hand, HELOCs usually have variable rates, which can drastically impact the amount owed over a long period of time. In addition to how interest rates are accounted for, how each is paid is also different. Home equity loans tend to follow a more structured payment plan. Simply put, these loans are usually paid back with a monthly fixed amount, accounting for both principal and interest payments with each installment. On the other hand, HELOC payments will be determined by the amount the homeowner borrows against their home and are subject to shifts in interest rates.
Primary Loan Vs HELOC
A primary loan refers to a traditional mortgage taken out to purchase a new property, while a HELOC on an investment property taps into existing equity. To effectively compare the two options, there are a few main differences to consider.
For example, investors tapping into existing equity may find this option to be more costly when compared to a traditional mortgage. As I mentioned above, the reason for this is because HELOCs on investment properties are generally considered to be riskier than those on primary residences. Some lenders may require multiple appraisals or longer waiting periods before approving a HELOC. Investors may also find they can secure lower interest rates when compared to a mortgage.
This is not to say a primary loan is necessarily the better choice compared to a HELOC on an investment property. Investors can and do tap into their existing equity all the time, despite certain trade-offs being involved. Just remember to carefully weigh the pros and cons of each option before making a decision.
HELOC For Investment Property Costs
The costs associated with a HELOC are similar to the closing costs of most other loans, including application, appraisal, and attorney fees. These costs generally range between two and five percent of the total loan. For example, if the rental property HELOC is for $20,000, the average closing costs would be between $400 and $1000. In some cases, lenders will waive some or all of these fees though this is not guaranteed.
A few other costs to be aware of include the potential for an annual maintenance fee, non-usage charges, or an early termination cost. Each of these fees will vary from lender to lender, and in some cases, may not apply. Investors should note each cost at the time of application and approval to avoid any surprises down the line.
Is HELOC On Rental Property Tax Deductible?
Thanks to the 2017 Tax Cuts and Jobs Act, property owners benefit from the ability to claim several tax deductions related to their mortgages. Taking out a HELOC on a rental property may bring you some tax advantages.
For starters, you can write off any expenses you incur as a rental property owner. This means that if you take out a HELOC on your rental property’s mortgage, then any interest you pay on the HELOC can be written off as an expense. This can help lower your overall taxable income.
How To Find A Lender For An Investment Property HELOC
The best way to find a lender for a HELOC on investment property assets is to leverage your existing network. This is because not all lenders will grant HELOCs for investment properties, making them somewhat tricky to find. Investors should ask mentors and other connections to learn more about HELOC providers. Be sure to consult your most recent lender, whether that be a traditional bank or otherwise, to learn if they know of any options. There will likely be a few potential lenders to choose from, allowing investors to choose from the best approval requirements and interest rates.
Aside from word-of-mouth referrals, investors can also research lenders online or contact previous connections to see what options are available. While it is easier to find HELOC providers for a primary residence, lenders are willing to do the same for investment properties. Often, smaller banks or credit unions are more likely to provide HELOC loans. Search online and be sure to confirm that they finance investment properties.
How To Qualify For An Investment Property HELOC
In order to qualify for a HELOC, borrowers must meet three specific requirements:
Debt-To-Income (DTI) Ratio
Know Your Credit Score
Lenders will pay special consideration to an investor’s credit score when evaluating a HELOC, as with most other sources of capital. After all, a credit score is a common indicator of whether a borrower is a risk. As a general rule, the better the credit score, the more likely an investor will qualify for a HELOC. However, it should be noted that there isn’t a universal standard for an acceptable credit score; different lenders have different criteria. What one lender may consider a ‘good score,’ another may consider poor or even risky. Traditionally, borrowers will want to boast a credit score of at least 740 if they want to tip the scales in their favor, but again, everyone is different.
Know Your Debt-To-Income Ratio
Along with a good credit score, borrowers will want to prove that taking out another loan won’t upset the balance they currently have between income and debt. Banks will calculate your debt-to-income ratio to see if you can afford to borrow more, in addition to what you already owe. However, unlike credit scores, lenders have set a precise debt-to-income ratio minimum: somewhere between 40 and 50 percent.
The single most important factor someone needs to qualify for a HELOC is equity. To be clear, a house has equity if the balance on the remaining mortgage is less than the house is worth. Therefore, any borrower with equity in their home has already met the first criteria for qualification.
Top 5 Benefits Of Using A HELOC For Investment Property
When it comes to financial stability, both homeowners and investors should be prepared with a plan. Using the equity in a home or investment property to pay for home upgrades or cover unexpected expenses (in the form of a HELOC) can be a great option for financially healthy individuals. Keep reading to discover more ways to use your home as a valuable tool.
Finance Home Improvements: One of the most common ways both homeowners and investors use HELOCs is to finance home improvement projects. In fact, the interest you pay on a home equity loan is usually only tax-deductible if you use the money for home-related projects (i.e., not for the purchase of a new car or vacation ticket). If you are a homeowner in a position to pay down a loan quickly, using a HELOC is a great option. However, if you believe it might take you longer the five years to pay down the loan, a refinance or cash-out refinance might be your best bet if you can secure a lower, fixed-rate interest.
Consolidate Debt: One of the best ways to consolidate credit card debt, other debt, or cover the finances that accompany a family emergency is by using your home’s equity. If unexpected expenses arise and you don’t have an emergency fund in place, a HELOC is an effective way to quickly access capital. The interest may not be tax-deductible (for example, using a HELOC to pay for medical expenses). However, HELOCs still typically come with lower interest rates than other debt consolidation vehicles. Paying this interest will also likely be cheaper than incurring capital gains taxes that come from selling other investments, especially if you know you only need the funds for a short period.
Move With Ease: If you are a homeowner who is planning to move, but you still need a little extra capital to fund your new down payment (or other moving expenses), using the equity of your current home as a financial tool can be a smart move. Note, however, that you typically won’t qualify for a HELOC if your home is already on the market, so be sure to plan ahead.
Dip Into Savings: Fun fact: most Americans carry the bulk of their savings in retirement accounts and plans like 401(k)s. However, withdraws from these accounts before the age of 59 ½ are subject to income taxes and possible penalties. This means, if you’re a homeowner or investor who needs to withdraw money for short-term expenses early, you’re not getting the biggest bang for your buck. So if you need additional capital before you retire, tapping into your HELOC can be helpful.
Boost Credit: When a lender approves your HELOC application, and you begin to make payments on the loan, the account will appear on your credit report. And guess what is the number one factor that affects your credit score…that’s right — your payment history with creditors. Once you begin to make consistent payments, it is likely your score will improve. Additionally, your credit rating will improve if you use less than 30 percent of your line of credit spending limit.
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Disadvantages Of Using A HELOC
Home Equity Lines of Credit have proven they can reward savvy investors with the funds they need, but that doesn’t mean there aren’t risks associated with borrowing against a home. To be clear, borrowing against a residence actually comes with at least a few significant disadvantages, which is why this strategy should be reserved for those who know exactly what they are getting into.
Without a doubt, the single riskiest aspect of using a HELOC has to do with using a property as collateral. When a lender grants a HELOC, the borrower’s home is secured as collateral. As a result, any neglect to pay off the loan could result in the loss of the property. Therefore, any attempt to use a HELOC must be met with due diligence and the utmost ability to pay back the loan; anything less is unacceptable.
Besides securing the loan with a physical property, HELOCs tend to come with a little more uncertainty than many are willing to accept. If, for nothing else, the rate one may receive on a HELOC can change. With variable rates, the costs of borrowing could increase dramatically. As a result, unsuspecting borrowers could find themselves with more expensive debt than they intended.
Alternatives To HELOCs
While numerous benefits come with using a HELOC on your home or investment property, there are alternatives to HELOCs that are still desirable. The following are a few examples:
Primary Residence HELOC: If you struggle to find a lender who will provide an investment property HELOC, consider tapping into the equity on your primary residence. While there are certain risks associated with leveraging your home, many investors find this to be a valuable source of financing. If you decide to pursue this option, keep an eye on interest rates and make sure you can always make your monthly repayment.
Home Equity Loan: The only slight difference between a HELOC and a home equity loan is the way borrowers can access their lines of credit. HELOCs have an open-ended line of credit similar to a credit card, while a home equity loan is typically set.
Cash Out Refinance: If you are unable to use a HELOC, which is essentially a second mortgage, consider refinancing your first mortgage. When you take out a new loan that is bigger than your existing one, cash is typically left over for you to use however you wish (hence the name, “cash-out” refinance). If you can get a lower interest rate, this strategy is a great alternative to HELOCs.
Personal Loan: When most people think about personal loans, they typically think about borrowing a few thousand dollars. Still, some personal loans let individuals borrow up to $35,000. Personal loans come with lower set-up costs than HELOCs and refinances, so if you need a little extra cash for just a short period, you’re in luck. However, keep in mind that these loans typically come with higher interest rates as an asset does not back the loan.
Cross Collateral: Another option for investors with multiple rental properties is to consider a cross collateral loan. This involves pooling your equity together for a line of credit, instead of using the equity from one property. However, the risk involved with defaulting then expands to those properties as well.
Using a HELOC on investment property can be a great way to tap into alternative sources of financing. After all, the more ways investors know how to fund a deal, the better off they will be. At the very least, having access to working capital is a great way to increase your bottom line if the money is invested wisely. If you are unable to access a HELOC, or perhaps want to pursue another option, there are several alternatives that can allow you to tap into your equity. Always consider your current portfolio and find the best opportunity to grow from there.
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The information presented is not intended to be used as the sole basis of any investment decisions, nor should it be construed as advice designed to meet the investment needs of any particular investor. Nothing provided shall constitute financial, tax, legal, or accounting advice or individually tailored investment advice. This information is for educational purposes only.