A home equity line of credit (HELOC) is one of many creative financing tools to use when investing in real estate. A HELOC can allow you to draw on a home’s equity to finance the down payment on another piece of real estate while still maintaining one monthly payment. But this comes with some caveats, especially when you're trying to do this for a rental property. Find out exactly how you can use a HELOC on rental property and what you need to consider before doing so.
What is a HELOC?
A HELOC has traditionally been used by homeowners on their primary residence. You pull money against the equity built up in your home in order to finance repairs, a car, or even a vacation property. A HELOC is similar to a credit card where you charge purchases to the credit line as necessary but have the option to leave it untapped until needed. This is not the same as a home equity loan, which is one lump sum, which immediately starts accruing interest.
But now investors are using this concept to purchase a new investment property. By getting a home equity line on a piece of real estate that was paid off or had increased in value, you can finance one or more additional investment properties. In many ways it's a useful strategy because you can choose when to draw on the HELOC when a deal or new opportunity becomes available. You don't have to pay interest on a loan that isn't working for you. This is a much cheaper option than alternatives like a high-interest hard money loan or trying to do a home equity loan, which could take too much time to close, causing the investor to miss the deal.
How can I use a HELOC on a rental property?
After the last housing crisis, financial guidelines and loan rules were tightened considerably. As an investor, you can still use a HELOC for investment property, but you will need to work with a lender who specializes in investment property line of credit. You will also more than likely have a higher interest rate than you would if it were a personal residence, but this is typical for most investment loans, not just a HELOC. As a side note, the scenarios we're discussing involve getting an investment property HELOC from a rental property you already own. If you are looking to purchase a rental property using your primary residence, you will fall into a different category and more than likely will have an easier time getting approved.
Using the home equity money allows the investor to purchase an additional investment property whenever the need comes up so that they have liquid funds. After closing on the second piece of real estate, many investors will then do a cash-out refinance and pay back the high-interest HELOC cash they pulled out. At that point, they will have the original property with the full amount of HELOC funds available plus the additional rental property that now has a second mortgage.
Special considerations when using a HELOC on a rental property
You will have more hurdles to overcome when getting approved than a borrower who lives in the property. This will include more equity in the real estate, a lower loan-to-value and debt-to- income ratio, and a higher credit score. You will end up paying a higher annual percentage rate or potentially paying points to keep it manageable, and the borrower will likely limit the number of rental property mortgages that you can carry at any one time. They will also require more insurance on the properties as well. This is all to reduce the risk of loan and make sure to the best of their ability that the borrower will be able to pay back the loan.
Another critical consideration when tapping into home equity is the tax implications. A HELOC is no longer tax deductible like typical mortgage interest is. The only use that is still deductible is for home improvements. That's why so many real estate investors will use this as a temporary solution to purchasing an additional property and then quickly follow up by refinancing. There are some accountants who utilize an interest-tracing approach and are able to get it tax deductible for certain situations, but this is an exception, not the rule. Talk with your accountant and have a solid plan for utilizing a HELOC so that you aren't surprised at the end of the year.
Getting a HELOC
When you've decided that an investment property loan, cash-out refi, or personal loan is not for you and that a HELOC on your rental property is a better option, you'll need to make sure you qualify for this type of home equity line. The first thing to do will be to find a lender who works with rental-property owners. You'll need a solid credit score as well as a low debt-to-income ratio. It's important to note that they will not count the full amount of rental income in this analysis so that you're able to cover unexpected expenses or a vacancy. They will also want to get appraisals on the rental property to determine the loan-to-value ratio. This allows the lender to determine the equity line amount and the mortgage rate they can offer you. Keep in mind that you will likely need cash reserves to cover a certain number of monthly payments, sometimes even the full amount, so the lender is more confident in your ability to cover the loan. Not only is it required by most lenders, but it just makes sound business sense as well.
There are many considerations when determining how to best finance your investments. A HELOC can be a useful tool but is typically not going to be your go-to financing technique, especially for a long-term hold like a rental property. The variable interest rate is typically too high, besides the uncertainty that comes when it's variable. Most lenders will only offer a variable rate on equity lines, but there are some who will do a fixed rate. Finding that can make a HELOC better suited to financing a rental property. Just make sure to talk to your tax accountant and lender before making any decisions.