A home equity loan allows you to borrow money against the value built up in your home. While most people seek out these loans using their primary residence, it is possible to get a home equity loan on a rental property – it just tends to be harder and more expensive.
In this article, we’ll go through the information you need to make an informed decision before taking out a home equity loan on a rental property. We’ll cover the potential benefits, risks and long-term implications of such a financial move, and common questions you may have.
Investment properties can provide passive income and build long-term wealth through equity growth. But profiting from real estate investments often requires capital – for down payments renovations maintenance, and more. If you don’t have cash on hand, tapping into your investment property’s equity through loans may help fund investments or cover expenses.
However, equity loans come with risks and limits. As an investor, you’ll want to understand how these financing options work, weigh the pros and cons, and choose the best approach for your situation.
What is Equity and How Can You Use It?
Equity represents your ownership stake in an asset For investment real estate, it’s the property’s market value minus any debts tied to the property.
You build equity in two key ways:
- Making mortgage payments – Each payment includes principal that increases your equity stake.
- Property appreciation – As the market value rises over time, your equity position improves.
Unlocking equity provides cash you can use for almost any purpose. Common uses of equity include:
- Funding a down payment on another investment property. This allows you to expand your portfolio.
- Financing renovations and upgrades to improve rents and property value.
- Tapping home equity lines of credit (HELOCs) to access funds as needed.
- Covering emergency expenses and repayment of high-interest debt.
Overview of Investment Property Equity Loan Options
Several loan products allow investors to tap equity in rental properties:
Cash-Out Refinance
With a cash-out refinance, you take out a new mortgage for more than what you currently owe. After paying off the old mortgage, you get the difference in cash.
Pros:
- Usually lower rates than other options
- Access to large lump sums
- Consolidate properties under one loan
Cons:
- Closing costs and fees
- Risk of overleveraging property
- Lost tax benefits of keeping original mortgage
Home Equity Loan
These fixed-rate loans let you borrow against equity. You receive funds in a lump sum.
Pros:
- Predictable payments
- Fixed rates
- Ability to borrow large amounts
Cons:
- Closing costs and fees
- Second lien increases risk
Home Equity Line of Credit (HELOC)
A HELOC provides a revolving credit line secured by equity. You can access as needed.
Pros:
- Interest-only payments during draw period
- Flexibility in when/how much you borrow
Cons:
- Variable rates often higher than alternatives
- Second lien increases risk
- Upfront fees and closing costs
Factors That Determine Your Equity Access
Your available equity depends on your loan-to-value (LTV) ratio – the amount you owe versus the property’s value. The higher your equity stake, the more cash you can potentially borrow.
Most lenders limit equity loans to 80% combined loan-to-value (CLTV) ratios. For example:
- Property Value: $400,000
- Existing Mortgage Debt: $200,000
- Maximum New Equity Loan: $160,000
This maintains a combined LTV of 80% and protects lenders in case of foreclosure. Some use a lower maximum CLTV for investment properties or high-risk borrowers.
Credit scores, income, and other debt also factor into equity loan eligibility and terms.
The Risks of Leveraging Real Estate Equity
Before using equity financing, consider the risks:
Less Equity Cushion – Equity protects you if values decline. Tapping equity reduces this cushion, increasing exposure to market swings.
Overleveraging – Excessive debt magnifies risk. Avoid borrowing to the max CLTV limit unless you can afford payments if rents fall.
Variable Rates – HELOC rates adjust with the market. Rising rates increase payments, stressing cash flow.
Missed Payments – If unable to make payments, you could face foreclosure and lose your property and invested equity.
Eviction Moratoriums – Laws freezing evictions limit rental income used to pay mortgages. Equity loans magnify risks from income loss.
Refinancing Difficulty – High debt-to-equity ratios can prevent refinancing if you need lower payments.
Tips for Using Equity Wisely as a Real Estate Investor
Follow these best practices to balance the benefits and risks of leveraging equity:
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Maintain a reasonable LTV ratio – Limit equity loans to 70% CLTV or lower unless you have ample reserves.
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Use fixed rates when possible – Variable HELOCs pose unpredictable payment risk.
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Focus on long-term investments – Don’t use equity on speculative or high-risk projects. Improvements that raise rents and value are ideal.
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Keep 6+ months of reserves – Cash buffers let you cover emergencies without tapping equity.
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Review loan terms carefully – Some lenders impose prepayment penalties and other gotchas.
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Consult a tax pro – Rules around interest deductions are complex. Understand implications.
Alternatives to Investment Property Equity Loans
If you want to avoid the risks of equity financing, other options exist:
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Personal loans – Unsecured loans avoid putting property at risk. Rates are often higher.
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Partners/private financing – Spread risk and unlock capital by bringing on co-investors.
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Sell non-core assets – Sell underperforming properties in your portfolio to raise funds.
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Cash-out refi on your primary home – Lower risk than using rental property equity as collateral.
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Peer-to-peer lending – Borrow from individuals rather than banks. Expand available capital.
The bottom line? Equity loans provide convenient access to your real estate investment’s stored value. But improper use magnifies risks and the potential for catastrophic loss. With prudent planning, however, investors can tap equity to systematically scale their portfolios and profit.
Pros of Home Equity Loans on a Rental Property
- Access to cash: Home equity loans provide rental property owners with cash for various purposes, such as property improvements, expanding their real estate portfolio or handling unexpected expenses.
- Lower interest rates compared to some other options: These loans often come with lower interest rates compared to unsecured personal loans or credit cards, potentially saving you money on interest payments over time.
- Potential tax deductions: The interest paid on a home equity loan for a rental property may be tax-deductible, reducing your overall tax liability and making it a financially efficient option.
- Possible improved property value: Using the loan to invest in property upgrades may increase your rental property’s value, potentially leading to higher rental income and property appreciation.
- Flexible use: Home equity loan funds are versatile and can be used for a wide range of purposes, providing flexibility in making strategic financial decisions for your rental property investments.
Should You Get a Home Equity Loan on a Rental Property?
Obtaining a home equity loan on a rental property is a decision that hinges on various factors unique to your financial circumstances. This section will explore some important considerations to help you determine whether this financial option aligns with your investment goals and risk tolerance.
Assessing your financial goals for your rental property is a fundamental step in determining whether a home equity loan is the right choice. Start by considering your long-term investment plans. Are you aiming for steady rental income, property appreciation or a combination of both? Knowing your objectives can help you decide if borrowing against your property’s equity aligns with your vision.
Additionally, consider how you’ll use the loan proceeds. Are you investing in property improvements to increase rental income or property value? Are you consolidating high-interest debt to improve cash flow? Understanding how the loan will support your financial goals will help you make an informed decision. A home equity loan can be a valuable tool for achieving these goals, but it should align with your overall investment strategy.
Analyze a rental property’s cash flow before considering a home equity loan. First, subtract your total expenses from your rental income. This will be your net income.
For example, let’s say your rental property generates $2,500 in monthly rental income, and your monthly expenses (including mortgage, property taxes, insurance, maintenance and management fees) total $1,800. This leaves you with $700 net income per month.
If you’re considering a home equity loan of $50,000 for property improvements, you may have a monthly payment of around $600 per month over 10 years, based on an interest rate of 7.75%. Factoring this in, you would only have a cash flow of $100 per month on your rental property. This may or may not be enough for you to consider the loan.
Here’s a step-by-step guide to weighing the costs and benefits of a home equity loan on a rental property:
- Calculate total loan costs: Determine the interest rate, fees and other costs associated with the home equity loan.
- Estimate potential gains: Evaluate how you plan to use the loan funds and consider factors like property improvements, rental income increase or property value appreciation.
- Assess interest rates: Compare the loan’s interest rate with other financing options to ensure it’s competitive.
- Review loan terms: Understand the loan’s terms, including repayment schedules and any penalties for early repayment.
- Consider property appreciation: Assess the potential for property value appreciation in your rental market.
- Project cash flow: Calculate expected cash flow, including loan payments, property expenses and rental income.
- Compare costs vs. benefits: Finally, compare the total loan costs with the potential gains in property value or rental income. Make sure the benefits justify the expenses and align with your investment goals.
This analysis can help you make an informed decision regarding the home equity loan’s financial viability for your rental property.
>> Related: Try out our home equity loan calculator
HELOCs for Rental Property Are BACK (Use Your Equity!)
FAQ
Can you pull equity out of investment property?
Do banks do HELOCs on investment properties?
Can you write off a home equity loan on a rental property?
Can you use home equity for down payment on investment property?
Can you buy an investment property with a home equity loan?
If you want to buy an investment property, there are several different financing strategies you can use. One option is to use a home equity loan to purchase the property. A home equity loan allows you to borrow money by tapping into your home’s equity. However, there are some risks to using a home equity loan to purchase an investment property.
Can I get a home equity line of credit on an investment property?
And if you have enough equity in your home, you might want to think about taking out a home equity line of credit (HELOC) on an investment property. While getting a HELOC on an investment property is possible, it’s not quite the same as getting a HELOC on your primary residence.
What can I do with my home equity loan?
Once your home equity loan has closed and you have picked out an investment property, you can use the proceeds from your home equity loan in any way you choose on your investment property, or anything else. The cash is yours to use as you wish after the loan closes.
What is a home equity loan & how does it work?
Home equity loan: Instead of a credit line, you can tap your investment property’s home equity and receive your payout in a lump sum. You’ll also enjoy a fixed interest rate, which means payments won’t change over time.