Should You Use Home Equity to Buy Investment Property?
While it may seem, there is no way to quickly build wealth, if you already own your home, you have at hand a useful tool for securing investment monies to create a passive income.
Using your home equity, you can obtain a home equity line of credit (HELOC) or home equity loan and use it to purchase an investment or rental property. This provides a cheap method of obtaining a quick infusion of money for investment, especially for buying a new home.
You can also take out a HELOC or home equity loan on an existing rental property that you own. You will likely receive less money than you would if obtaining the loan or line of credit using your primary home, but you avoid the danger of having an open loan on your primary home, typically your residence.
Home Equity Funds Have Fewer Restrictions
The main advantage to using a home equity loan or HELOC for funding another property purchase is lenders typically don’t restrict the use of the money. It lets you secure a very low rate of interest for the rental property or investment property purchase without taking out a second mortgage. You can easily buy a fixer-upper and use the same funds to make repairs or renovate the property. That’s just how unrestricted your use of a HELOC really comes. Talk about unencumbered funding. You will also find the interest rates for a home equity loan or HELOC that much lower than obtaining a personal loan or using a credit card to fund the repairs.
How Much Can You Get?
This varies by the financial lending institution, but as a general rule, the maximum you can obtain equals 90 percent of your loan-to-value ratio. This results in a combined loan-to-value ratio (LTV) of 85 percent though.
Combined, you ask?
That refers to a combination of your mortgage and your home equity loan. Here’s how the math works on this stuff.
You have a house valued at $200,000. You’ve paid off $80,000 of your mortgage, so you have a bit of equity built. Your mortgage balance is $120,000. Divide your remaining mortgage balance of $120,000 by the total mortgage of $200,000 to obtain your current loan-to-value ratio, in this example, 60 percent.
Remaining Mortgage Value/Home Value = Loan-to-Value Ratio
Since your bank only lets you undertake loans of up to 85 percent of your home’s value, you have 25 percent available, 85 – 60 = 25.
Maximum Bank LTV – Your LTV = Available LTV
Calculating 25 percent of your home’s value, you obtain the maximum home equity loan or HELOC for which you can qualify.
$200,000 x 25 = $50,000
Total Home Value x Available LTV = Potential HELOC or Home Equity Loan Amount
That means the maximum amount of debt your bank will allow you to carry equals your current mortgage to be paid plus the HELOC/home equity loan, or $120,000 + $50,000 = $170,000.
Why Use Home Equity to Obtain Investment Property?
Besides how easily you can obtain these funds and their flexibility in use, using home equity to buy investment property offers many other advantages, too. Among these perks include:
Obtain lower interest rates. Perhaps you would not typically qualify for a prime interest rate, but this method of borrowing lets you land that low-interest rate as if you have a 750-credit score. Compared to unsecured debt, a HELOC comes cheap.
Use that beautiful equity. Your home equity comprises one component of your net worth. You can make this work for you by leveraging it to build wealth.
Lender-debtor trust. You and your bank already have an established relationship. You can more easily obtain a loan from a lender with whom you have an established, positive relationship than one from whom you have never done business.
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Potentially Risky Business
I’m not going to lie to you, although I am pausing for another cup of coffee. You should, too. Or tea. Whatever floats your boat.
There is Risk with a capital “R” in using your primary home in this way. It’s a lot like putting it up as collateral for some huge expense.
In fact, that really is what you are doing. You put your home at risk by accessing your house equity.
If anything happens to make it where you cannot make loan or HELOC payments, then your bank will foreclose on your loan/HELOC.
The Fees for Use
Although not really a risk, there is added expense. Unlike a personal loan, you get charged closing costs and fees just like when you closed on your home. They may not cost as much as the closing costs and fees on your mortgage, but they exist. This is a small trade-off for the much lower interest rates though. Since interest must get paid every month, but the fees are one-time and usually small, this works out nicely.
Home Equity Loan or HELOC?
The two choices differ in a few really important ways. This ranges from the way you draw on the money to how you pay taxes on it.
Home Equity Loans
You obtain a lump sum payment at a fixed interest rate. You make monthly payments to the lender for a fixed time period, typically ranging from 10 to 15 years. The lender bases the loan amount on your home’s equity.
Home Equity Loan or HELOC?
HELOC
This also gets based on the home equity you have built, but you can draw on it many times during the time period set in the HELOC. It offers variable interest rates subject to market fluctuations.
Choosing between the two. If you just need money for a down payment on a property, choose the home equity loan for its predictable repayment. If you need a massive line of credit for home renovations on multiple properties or a single large one, choose the HELOC. Both offer a tax deduction if you use the loan or HELOC to improve the property used as collateral in the loan. If you use this on an investment property though, you lose the deduction. The law changed in 2018.
Other Options for Accessing Money
These do not provide your only options. You can also consider a second mortgage or a cash-out refinancing. These do not avoid risk either though. There really is not a way to invest that is completely risk-free.
The second mortgage only puts your credit score at risk though if you cannot make payments. You can obtain a larger amount of money this way plus you do not put your home at risk as collateral. They do have higher qualifications though and higher interest rates. You also pay closing costs.
With cash-out refinance, you refinance your first mortgage for a larger amount than you currently owe. You obtain the excess amount as a lump sum. You get to spend the lump sum as you see fit. You can obtain lower interest rates than with a home equity loan or HELOC. You can also deduct the money, up to $750,000, on your federal taxes. You still pay closing costs.
Learning More About Financial Management
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