You can take out a HELOC on your investment property if you’ve built up a sizable amount of equity. But is it a smart financial move? It depends on your financial profile and why you want to convert your equity into cash.
What is a HELOC?
A home equity line of credit (HELOC) is a second mortgage. Similar to a credit card, it allows withdrawals up to a preset limit during the draw period and replenishes as you make payments.
HELOCs come with a variable interest rate, which means the monthly payments will fluctuate over time. Most lenders let you make interest-only payments during the draw period – typically between five and 20 years. But once it ends, you’ll also begin paying toward the principal balance.
Relevance of HELOC on Investment Property
Here’s what to know about HELOCs as they relate to investment properties.
What Counts as an Investment Property?
In short, an investment property is a type of property purchased to generate income. Think of rental homes and multi-family units that you will rent out solely to turn a profit.
Can You Get a HELOC on Investment Property?
Some lenders will approve you for a HELOC on an investment property if you meet their guidelines. However, expect more stringent eligibility guidelines, as the risk of default is higher.
The amount you can access depends on your credit score and debt-to-income ratio, and you should have at least 20% in home equity. Lenders also cap the amount of equity you can tap into – typically up to 85%.
To illustrate, if your rental property is worth $350,000 and you owe $175,000, you could potentially access $122,500. Here’s the calculation: $350,000 * 0.85 – $175,000.
Usage Scenarios
Lenders generally don’t impose spending restrictions on funds borrowed through a HELOC. That said, many borrowers borrow money to fund renovations or repairs that will increase the property value and command higher rents.
You can also borrow funds to make a down payment on an additional investment property. This is an easier way to expand your rental portfolio and could lead to even greater returns over time.
The Benefits of a HELOC on Investment Property
Here are some reasons why taking out a HELOC against an investment property could be beneficial.
Access to Equity
As previously mentioned, a HELOC lets you tap into the equity built up in the investment property. The equity is the difference between what the property is worth and what you currently owe on the mortgage.
Flexible Borrowing
You’re in control of what you borrow with a HELOC. However, with a home equity loan or other type of installment loan, you receive a lump sum upon approval and must pay interest on the amount you borrow. Plus, the monthly payment amount is set in stone over the loan term. And repaying the balance early could lead to prepayment penalties.
Potential Tax Advantages
If you use the funds from a HELOC to make qualifying home improvements, you could be eligible for breaks at tax time. Be sure to consult with a tax professional to confirm or learn more.
Risks and Considerations of a HELOC on Investment Property
Before applying for a HELOC on an investment property, you should also be aware of these potential drawbacks.
Fluctuating Interest Rates
As previously mentioned, most HELOCs come with variable interest rates. So, you’ll get monthly payments that change with market conditions, potentially leading to much steeper borrowing costs than you envisioned. A fluctuating interest rate can also make it hard to budget for monthly HELOC payments.
Impact on Property Value
When you take out a HELOC, the amount of equity in your home drops. This could be problematic if you plan to sell soon and market conditions change, as a drop in your property’s value means lower profit margins. Even if you don’t plan to sell, you could find it challenging to refinance if the current mortgage is underwater (or you owe more than the home is worth).
Loan-to-Value Ratio (LTV) Limits
Most lenders require a certain loan-to-value (LTV) ratio to approve a HELOC on an investment property. This ratio often doesn’t exceed 80% of the property’s value after drawing the full loan amount. LTV limits are also important because they determine how much equity you can access.
If your property’s value drops, your LTV ratio could become problematic, leading to higher interest rates or even a demand for additional payments. Maintaining a low LTV ratio protects against market fluctuations and helps keep your HELOC terms favorable.
HELOC Eligibility and Requirements for Investment Property
Are you still considering a HELOC after weighing the pros and cons? Here’s what’s needed to qualify.
Credit Score and History
Most lenders require a credit score of at least 700. Furthermore, your credit history should be positive and demonstrate your ability to manage debt obligations over time responsibly.
Property Appraisal
Lenders also require an appraisal of the property to learn its current market value. This figure is used to calculate how much equity is available and the amount you can access through a HELOC. Again, you should have at least 20% in home equity to qualify for a HELOC on an investment property.
Debt-to-Income Ratio (DTI)
Your debt-to-income (DTI), which represents the percentage of your gross monthly income used to cover debt obligations, is also considered. It should be below 41% to have the best chance of securing a HELOC with competitive terms. If there are other compensating factors, like a hefty source of income and reserves, the lender may be a bit more flexible here.
How to Apply for a HELOC on Investment Property
Are you ready to take the next step? Here’s how to move forward with securing a HELOC against your rental property.
Preparing Documentation
Gather proof of income (i.e., pay stubs, W-2 forms), recent bank statements, tax returns and details of all outstanding debts. It’s worth reaching out to the lender before applying so you’ll know what documents are needed to process your application and can prepare them beforehand.
Finding the Right Lender
Look for lenders specializing in HELOCs for investment properties, as not all do. Compare interest rates, fees and terms different lenders offer to find the best option.
Formally Apply for a Loan
Complete the lender’s application form in its entirety and upload the requested documentation promptly. The lender will assess your credit score, home equity, debt-to-income (DTI) ratio and other financial information to determine whether you’re a good fit for a HELOC.
Seal the Deal
If approved, the lender will order a property appraisal. Once the appraisal confirms you have an adequate amount of equity in the property, the lender will finalize the terms of your HELOC. You’ll then sign the loan agreement, and the lender will open a line of credit against your investment property, allowing you to access funds as needed.
Other Considerations on Getting a HELOC on Investment Property
Tax Implications
As previously mentioned, there are tax perks if you use a HELOC to fund qualifying home improvements. But you’ll need to confirm your eligibility before commencing the home renovation project(s).
Management and Repayment
The variable interest rate you’ll get with a HELOC could make it challenging to manage your monthly payments responsibly. So, be sure to only borrow what you can comfortably afford to repay, and consider paying above the minimum during the draw period to reduce the principal balance before it ends.
Comparing HELOC to Other Financing Options
It’s also worth exploring home equity loans and cash-out refinances to gauge if they are ideal options. Home equity loans also act as second mortgages, while cash-out refinances require you to swap out your current home loan for a new one. Still, both let you tap into your equity and could work for your financial situation. Speak with a lender or financial advisor to learn more.
Conclusion: When Is Getting a HELOC on Investment Property a Good Idea?
Getting a HELOC on an investment property can be a good idea when you need flexible financing for property improvements, repairs, or to expand your portfolio of properties. It allows you to leverage the equity in your property without selling it, often with lower interest rates than other loan types. However, it’s important to ensure that the potential returns outweigh the financial risks and costs associated with variable interest rates and fluctuating monthly loan payments.
