If you own a second home that you rent out, a full-time rental property or another investment property, you may be wondering how to get the most value from your real estate investment.
One way to do it is with a home equity line of credit (HELOC). As the name suggests, you can use this type of loan to borrow against a home’s available equity (which is the difference between what you owe and the value of your property).
But is it the right option for you? Read on to find out.
What Is a Home Equity Line of Credit (HELOC)?
A HELOC lets you borrow against the equity in your home. It’s similar to a home equity loan, but with a HELOC, there’s greater flexibility around how and when you access equity. It’s a little bit like a credit card, but with lower interest rates.
Most HELOCs have two stages:
- The draw period: For the first 5 – 10 years, you can draw from your home equity, and you only need to make minimum monthly payments to cover the interest on the line of credit. As you pay down your loan balance, you can continue to draw on the available home equity.
- The repayment period: After the draw period, you won’t be able to draw from your home equity anymore. You’ll have up to 20 years to pay off the remaining balance.
HELOCs often come with variable interest rates that go up or down based on market interest rates. Depending on the terms of your HELOC, the interest rate can change every month or year.
HELOC vs. Home equity loan
A home equity loan pays you a lump sum in advance and usually comes with a fixed interest rate. The interest rates on home equity loans are usually a little lower, but you start making monthly loan repayments right away.
Why Take Out a HELOC on an Investment Property?
If you have an investment property, you want to get the most value from it. Taking advantage of available equity can help you further your financial goals. If you have enough equity in your investment property, you can use it to:
- Make a down payment on another investment property
- Renovate or repair your existing property
- Pay down higher-interest debt
HELOCs offer greater flexibility because you can choose to use the money when you need it. You can make multiple payments to multiple vendors by check or debit card, and you can set up a line of credit and leave it for emergencies or future plans.
Should You Take Out a HELOC on Your Investment Property?
There are lots of reasons why you would want to take out a HELOC on a rental property or your investment property. But there are costs and risks to consider before you commit.
The interest can get expensive
Typically, the interest rate on a HELOC is lower than the interest rate on a personal loan or credit card. However, the interest rate on a HELOC for an investment property will be more expensive than the interest rate on a HELOC for a primary residence.
Lenders know that if things go wrong, homeowners will prioritize mortgage payments on their primary residence over their investment property. To offset the increased risk of loan default on the investment property, lenders will charge a higher interest rate.
The interest rate can change
Because HELOCs come with a variable interest rate, it can be difficult to predict how much you’ll need to set aside to cover your monthly payments.
Read the terms of your HELOC to learn what the maximum cap is on your interest terms. That way, you won’t be completely surprised if the HELOC you took out with 7% interest suddenly spikes to 20% by the time you reach the repayment period.
The payments can catch up with you
HELOCs are like credit cards – which can be both beneficial and dangerous. It’s beneficial because HELOCs offer greater flexibility. During the draw period, you can borrow more and only have to worry about making minimum payments. It can get dangerous because it’s easy (and tempting) to rack up debt.
If you don’t keep up with your payments, you may find yourself owing more than you can afford each month, especially if interest rates go up.
You risk losing your investment property
The interest rates on HELOCs are more competitive than the interest rates on personal loans or credit cards because they’re secured loans. That means you’re using your investment property as collateral.
If you miss payments, a lender can foreclose on your investment property. That means all the time, money and sweat you put into the property could vanish alongside the future income you would’ve earned.
How Do You Qualify for a HELOC on a Rental or Investment Property?
Before a lender can approve you for a HELOC on an investment property, they must consider your:
You can usually qualify for a HELOC on your primary residence with a credit score of 620 or higher. Lenders usually want higher credit scores to qualify for a HELOC on an investment property. If you can’t meet the credit score threshold, they will likely charge you more in interest.
To get the best interest rates on a HELOC for an investment property, you’ll want to aim for a credit score of 740 or higher.
Combined loan-to-value (CLTV) ratio
Lenders usually require that you maintain a CLTV of 75% – 80%. That means that the amount you owe on your existing mortgage and the amount you borrow using a HELOC can’t be more than 75% – 80% of the property’s value.
Let’s say your investment property is worth $200,000, and you owe $120,000 on the mortgage.
Assuming your CTLV is 75% – 80% of the value of the property, you can only borrow $150,000 – $160,000. If you deducted $120,000 from $150,000 and $160,000, you’d only be able to borrow between $30,000 – $40,000 with a HELOC.
To qualify for a HELOC on an investment property, lenders will want to see that you have at least 2% of your unpaid principal balance (UPB) or the remaining balance on your mortgage saved and readily available in case of emergencies or rental income shortfalls.
This often equals enough to cover 2 – 6 months of minimum mortgage payments, which includes the principal, interest, taxes, insurance and association dues (PITIA). Some lenders may require as much as 12 – 36 months (1 – 3 years) in cash reserves.
You can keep the money in a savings account, checking account, CD, money market account or keep liquid assets (like stocks or bonds) in a brokerage account. Lenders usually won’t consider money in a retirement account, like a 401(k) or IRA.
Your lender will want to see that your investment property is earning money. That means you’ll need to provide them with a breakdown of how much you’re collecting in rent each month.
Lenders also like stability. Too many short-term tenants (renting for a year or less) may raise a red flag, suggesting that there’s something undesirable about the property or how it’s managed.
What Kind of Tax Benefits Can I Get With a HELOC on an Investment Property?
Investment properties come with many tax benefits, including the ability to write off a portion of the mortgage interest on a HELOC. Writing off the mortgage interest lets you lower your income on your tax return, so you pay less overall.
However, the 2017 Tax Cuts and Jobs Act (TCJA) changed the rules in two key ways.
Lower mortgage interest deduction
Before the TCJA, you could deduct interest on up to $1 million in mortgage debt.
If you owed $300,000 in mortgage debt on your primary residence and $450,000 on your investment property and then took out a HELOC for $100,000, you’d be able to deduct mortgage interest on all three loans.
The TCJA lowered that limit to $750,000.
With the new limit, you can write off the mortgage interest on the $300,000 and $450,000 loans, but you can’t deduct the mortgage interest on the HELOC.
HELOC interest deduction limitations
Another TCJA provision is that you can only deduct mortgage interest on a HELOC if you use the money to buy, build or repair the property you’re borrowing against.
With a HELOC on an investment property, you can write off the interest if you use the money to upgrade the property or to buy another property. You can’t write off the interest if you use the money to pay off personal debts.
What Are the Alternatives to a HELOC on Your Investment Property?
If a HELOC on an investment property doesn’t make sense for you, there are other ways to borrow the money you need.
A cash-out refinance is essentially a new mortgage on your investment property. The difference between a cash-out refi and a standard refi is that you can borrow more than you owe (which you can only do with enough equity).
You use the new mortgage to pay off the original mortgage and pocket any leftover money. The key difference between a cash-out refi and a HELOC is that, with a cash-out refi, you immediately start paying interest on the loan and lose the “draw when you need it” flexibility of a HELOC.
HELOC on your primary residence
If you’re concerned about the higher interest rates that come with HELOCs on investment properties or you don’t have enough equity in your investment property, you could take out a HELOC on your primary residence.
This could be a more affordable option, but keep in mind that you’d be putting your home at risk if you couldn’t make your payments.
Unsecured personal loan
If you have good credit but don’t have the time to wait on a HELOC, you may be able to take out an unsecured personal loan. With these loans, you can usually borrow up to $100,000 (depending on your credit) and get the money in 1 – 7 business days.
Just be aware that the interest rates on these loans will be higher than a HELOC, and you’ll need to start making payments right away.
Is a HELOC on an Investment Property Right For You?
If you have an investment property, a HELOC can be a great way to put the equity in the property to good use. You can use it to upgrade your existing property or expand your real estate empire.
Like any loan, a HELOC on an investment property comes with its risks and costs. Make sure you talk to your lenders and financial advisor before you make any decisions.
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