If youown more than one property, you can borrow against any equity you’ve built up to fund a significant expense.
When you take out ahome equity loanand use your home as collateral, it’s important to be aware of the benefits and drawbacks, however. For a home equity loan, an investment property and rental property are treated the same; you can borrow against the equity in either.
Here’s what you should know about borrowing against your equity in a rental property (or other non-primary residence) and why other types of financing may be a safer bet.
What is home equity?
Your home equity is the difference between what you owe on your mortgage and the current value of your home. You buildequity in your homeby consistently making mortgage payments over the years. Most lenders will expect you to have at least 15% to 20% equity in order to approve you to borrow money against your primary residence. When it comes to a rental property, however, lenders typically require higher levels of equity for approval because it’s a riskier loan for them.
Risks of using home equity to finance a second property
Using a home equity loan or HELOC to borrow against an investment property is a risky move. It means you’ll be on the hook for three mortgage payments a month, which is a major financial commitment even if you can comfortably afford the payments.
The use of home equity loans and home equity lines of credit, orHELOCs, hit record highs during the pandemic thanks to soaring home values and low interest rates that made borrowing money cheap. However, as the Federal Reserveratcheted up ratesthrough 2022 and beyond, borrowing against a home, whether it’s a primary residence or not, has become dramatically more expensive.
“Home equity rates are the highest they’ve been in 15 years, and it’s going to cost you even more on something other than a principal residence,” says Greg McBride, chief financial analyst for CNET’s sister site Bankrate. “People often look at home equity as found money. But it’s no longer a cheap source of borrowing with the way rates have gone up this year.”
What is a home equity loan?
Ahome equity loanlets you borrow money against your existing equity and provides you with a lump sum of cash at a fixed interest rate and a fixed repayment schedule. Your monthly payments will always be consistent and your interest rate will never change.
What is a HELOC?
AHELOCis a revolving line of credit that works more like a credit card. You don’t receive your funds all at once and instead you can make as many withdrawals as you need over an extended period of time. HELOCs have variable interest rates, so your monthly payments will fluctuate, compared to home equity loan payments which stay consistent.
What is a rental property?
A rental property is any property you buy with the intention of generating income by renting it to tenants. Any rental property you use to make money can also be referred to as an investment property.
How to get a home equity loan or HELOC on a rental property
As with any loan or mortgage, you’ll want to have all of your financial ducks in a row before applying. Although home appraisals may now be done virtually, it’s likely your lender will require one or two in-person appraisals to confirm your home’s value.
Calculate your loan-to-value ratio
Calculate your loan-to-value, or LTV, ratio, which is simply the current appraised value of your home divided by the remaining balance. Mostlenders prefer an LTV of 85% or lessfor primary residences, but will likely require an even lower LTV for an investment property.
Review your credit history
In addition to your available equity, lenders generally require a credit score of 700 or higher to make this kind of loan. The higher your score, the better rates and terms lenders will offer you. Before you apply,review your credit reportfor accuracy. For a primary residence, lenders typically want you to have a debt-to-income or DTI, ratio between 36% to 43%. For a rental home, the threshold may be lower.
Get your financial paperwork together
You’ll need to demonstrate you can pay back your loan over time by providing proof of income and employment with tax returns, pay stubs and W-2s. You’ll also be required to show current mortgage statements for the homes you already own to show that you’ve been making on-time payments. For a rental property, you’ll have to show proof of rental insurance, and also likely be required to provide copies of your tenants leases’ to demonstrate that the home is occupied and generating income.
Compare lenders
Not all lenders offer home equity loans or HELOCs for investment properties because they tend to be riskier. The more lenders you interview, the better your chances of finding the most favorable rates and terms. Some lenders may offer lower interest rates that appear less expensive, but include higher fees that could cancel out any potential savings. Make sure you understand the total cost involved, including any additional lender and third-party fees.
Alternatives to a home equity loan or HELOC when financing a rental property
There are other types of financing that don’t require you to take a second mortgage out on your rental home. And at current interest rates, you may not save all that much with a home equity loan or HELOC compared to another type of loan.
“There’s a lot of home equity rates that have reached double digits and they’re still going up becausethe Fed is still raising rates,” says McBride. “You’re not going to get a bargain by tapping into equity on a rental property or an investment property.”
Personal loan:Apersonal loanis an unsecured loan so it will have a higher interest rate and lower credit limit than a home equity loan, but it won’t require you to put your rental up for collateral. The average personal loan rate is several percentage points higher than a HELOC, according to Bankrate.
Cash-out refinance:Acash-out refireplaces your current mortgage with a new mortgage that has more favorable rates and terms. The equity you borrow is added back onto the balance of your new mortgage and you pay it off over your loan term. But with interest rates near their highest levels in two decades, this option probably won’t make sense for most homeowners who’ve already locked in a lower rate.
Credit cards:Acredit cardis also unsecured debt that will have a higher interest rate than a home equity loan, but you won’t be at risk of foreclosure and you may benefit from credit card rewards programs, too.
The bottom line
You can take out a home equity loan on a rental property, but doing so means you’ll have to pay three mortgages every month. When you borrow against your home equity you are using the property as collateral to secure the loan, so if you default for any reason your lender can repossess the house. With interest rates continuing to rise and home equity rates at a 15-year high, it’s not worth the risk of foreclosure to borrow against an investment property if you have access to other types of financing.
