Should You Take Out an Equity Loan on a Rental Property?

Taking out a home equity loan against a rental or investment property can seem tempting, especially if you need access to cash quickly. However, there are some major risks and drawbacks to consider before moving forward with this type of financing. In this comprehensive guide, I’ll walk through everything you need to know about equity loans on rental properties so you can make an informed decision.

What is a Home Equity Loan?

A home equity loan is a type of loan that allows homeowners to borrow against the equity they have built up in their home. Equity refers to the current market value of your home minus any outstanding mortgage debt

For example, if your home is worth $500,000 and you owe $300,000 on your mortgage, you have $200,000 in equity. With a home equity loan, you can access some of that equity – let’s say $50,000 – in a lump sum. The loan would be secured by your home, meaning if you default, the lender can foreclose.

Home equity loans have fixed interest rates and terms ranging from 5 to 30 years, You pay back the loan plus interest with fixed monthly payments over the loan term

The Potential Risks of an Equity Loan on a Rental

While it may seem straightforward to tap into your rental property’s equity, there are some major risks to be aware of:

• Increased debt burden: With a home equity loan, you are taking on another monthly debt obligation on top of your existing mortgage payments. This significantly increases your risk if your income takes a hit.

• Variable rental income: Rental income often fluctuates month-to-month, especially if you have tenant turnover. This unpredictability makes a fixed monthly loan payment more difficult to manage.

• Potential for foreclosure: If you fall behind on home equity loan payments, you could lose the rental property to foreclosure. Additionally, defaulting on the rental loan could impact your credit and potentially threaten your primary residence.

• Rising interest rates: Home equity loans have fixed rates, but if interest rates go up significantly over the loan term, you can end up paying much more in interest than expected.

• Difficulty getting approved: Lenders tend to have higher standards for a non-owner occupied property. You’ll likely need excellent credit, low debt-to-income, and at least 15-20% equity.

As you can see, equity loans on investment properties come with substantial financial risks that require careful consideration.

Home Equity Loan Requirements

If you decide to pursue a home equity loan on a rental property, here are some common requirements to prepare for:

• Credit score: Expect a minimum credit score of 660-720. The higher your score, the better.

• Loan-to-value (LTV) ratio: Most lenders require a maximum LTV of 80-85% for a rental property, meaning you’ll need at least 15-20% equity.

• Debt-to-income ratio: Lenders may require a DTI below 40% to approve a loan for a rental property.

• Appraisal: The lender will require a full appraisal on the rental property to verify its value and determine the amount you can borrow.

• Rental income: You must provide documentation like tax returns and lease agreements to confirm the property generates steady rental income.

• Occupancy: Evidence that the property is occupied by tenants and that you have rental property insurance.

• Employment and income: Documents like W-2s and paystubs to prove your income and ability to repay the loan.

Meeting all these requirements can be challenging compared to getting a home equity loan on your primary residence. Be sure you fully qualify before applying.

Alternatives to a Home Equity Loan

Given the risks and barriers to getting approved for a home equity loan on a rental, you may want to consider alternative financing options:

• Cash-out refinance: If rates are lower now, you may be able to refinance the rental property’s existing mortgage and take cash out of the new higher loan amount. This avoids a second loan payment.

• Personal loan: Unsecured personal loans have higher rates but don’t put your property at risk. Look for terms of 3-5 years to match how long you need the funds.

• Business line of credit: If you own the rental in an LLC, a business line of credit can provide flexible access to funds without as much risk.

• Credit cards: Putting expenses on a 0% APR credit card can make sense for very short term financing needs of less than 1 year.

• Hard money loan: These specialized high-interest loans are easier to qualify for if you have a lot of equity but don’t meet traditional lending standards.

• Private lender: As a last resort, private lenders provide loans at higher rates to riskier borrowers. But their terms are not ideal for long-term financing.

Carefully weigh the pros and cons of each option based on your specific situation and financial needs.

Questions to Ask Before Getting an Equity Loan

If you decide to pursue a home equity loan on a rental property, here are some key questions to ask yourself:

• How much cash do I need right now? Can I qualify for a smaller loan amount?
• How long will I need the loan for? How do loan terms and rates compare?
• Can I afford the new monthly loan payment plus existing expenses?
• What happens if the property stays vacant for an extended period?
• How stable and predictable is my income? Could I weather a financial emergency?
• Am I comfortable with the risk of foreclosure if I default?
• What other alternatives like a business line of credit are available to me?
• Does it make sense to tap equity now with interest rates high and possibly rising further?

Thinking through questions like these will help you determine if a home equity loan is truly the right financial move for your situation.

Tips for Getting Approved

If you’ve weighed the risks and still want to get a home equity loan on a rental property, here are some tips to improve your chances of getting approved:

• Shop around with multiple lenders to compare rates and fees. Consider credit unions, which may offer more competitive pricing.
• Ask the lender if you’d qualify for a loan before formally applying so you don’t damage your credit with too many inquiries.
• Work on improving your credit score and paying down existing debts to reduce your DTI.
• Be prepared to provide lots of documentation proving income, rental occupancy, insurance, etc.
• Consider asking your current lender if they will approve you for a home equity loan since they already have your business.
• Offer to put down a larger down payment of 25-30% to make the loan less risky for the lender.
• Patience pays off – take time finding the right loan program and deal.

With proper preparation, you can potentially get approved, but make sure the numbers still make solid financial sense for your situation.

Weighing the Pros and Cons

Clearly, home equity loans on rental properties involve a complicated set of trade-offs. Here’s a quick recap of some of the key pros and cons:

Potential Pros

• Access to lump sum funds quickly
• Potentially lower interest rate than alternatives
• Fixed monthly payments
• Ability to make property improvements to boost rents

Potential Cons

• Risk of foreclosure if you default
• Inflexible loan terms and payment amounts
• Difficult to qualify for the loan
• Rising interest rates increase costs over loan term
• Owning property free and clear is lost

Again, weigh these options very carefully in the context of your personal financial situation. While the loan may make sense on paper, the risks may outweigh any potential reward.

The Bottom Line

Tapping into home equity can provide convenient access to cash, but equity loans on rental properties come with major financial risks that need to be taken very seriously. From increased debt obligations to foreclosure risks to financing alternatives, make sure you consider the full picture.

If you have excellent credit, sufficient equity, predictable income, and a solid business plan for the money, a home equity loan on a rental may end up working to your benefit. But proceed with extreme caution – never view the equity you’ve built up as easy money or a guarantee.

What are your thoughts on home equity loans for rental properties? I’d love to hear your take! Feel free to share your experiences and advice in the comments below.