A home equity loan allows you to tap into the value of your property to get a lump sum that can be used for any purpose. Most homeowners take out this loan on their primary residence. But can you take out a home equity loan on an investment property or rental property?
If you have enough equity, it’s possible, but the application process may be more difficult, and you may have to pay higher interest rates and additional costs.
So, if you are considering a mortgage for a rental or investment property, here are some facts to consider.
Can I get a mortgage on a rental property?
The short answer is, yes, it is possible to get a mortgage on a rental property.
But in the eyes of a mortgage lender, an investment property may be a riskier proposition: Because you’re less likely to rely on your rental property as a residence, there’s less risk if you default on your mortgage and you’re more likely to simply give up and cut your losses (at least that’s how lenders see it). In other words, a rental property doesn’t offer the same security as a home as collateral.
Because of this risk, it may be difficult to find a lender who will give you a mortgage on an investment property or rental property, and if you do, you’ll probably end up paying more interest to compensate for the risk.
Mortgage Requirements for Investment Properties
Mortgage requirements for investment and rental properties vary by lender, but they tend to be stricter than home-secured loans. You’re essentially falling into the realm of business loans. Generally, you’ll need the following:
- Minimum credit score: 700 or higher
- Maximum Debt-to-Income Ratio (DTI): 43% (up to 50% in some cases)
- Maximum Loan-to-Value Ratio (LTV): 75%
- Reserves: 6 to 15 months of mortgage repayments
Lenders may also look at a property’s revenue track record. A history of steady positive cash flow and high occupancy is a plus. In contrast, high turnover and long periods without income could be a potential red flag for a lender.
HELOC or Home Equity Loan: Which is better when tapping into the equity in your investment property?
Choosing between a Home Equity Line of Credit (HELOC) and a Home Equity Loan to leverage the equity in your investment property depends on a variety of factors, including your financial goals, risk tolerance, and specific circumstances. Here’s a quick comparison of the two products:
Mortgage-backed securities
- Flexibility: A HELOC provides a revolving line of credit, allowing you to borrow funds as needed up to a certain limit and repay them over time.
- Variable interest rate: HELOCs usually have variable interest rates that change with market conditions, meaning your monthly payments can fluctuate.
- Interest-only payments: During the drawdown period (usually 5-10 years), you only have to pay interest payments, and then during the repayment period, you’ll have to make principal and interest payments.
- risk: HELOCs are riskier because interest rates can rise, which could result in higher monthly payments.
Home Equity Loans
- One-time payment: With a mortgage, you receive a lump sum payment up front and repay it at a fixed interest rate over a set period of time.
- Predictable payments: Home equity loans have fixed interest rates and repayment terms, so your monthly payments remain constant over the life of the loan.
- risk: Home equity loans have lower interest rates than HELOCs, but if interest rates across the board fall, you’ll end up paying more in the long run.
When choosing between a HELOC and a home equity loan to leverage the equity in your investment property, consider the following factors.
- How do you plan to spend the funds? If you need ongoing access to funds for various expenses or long-term projects, as is the case with a multi-unit property, a HELOC may be a better choice. If you have a specific expense or project in mind, a home equity loan may be a better choice.
- What is an interest rate forecast? If you expect interest rates to rise, a fixed-rate mortgage may offer more stability, while if interest rates are low or expected to fall, an adjustable-rate HELOC may be attractive.
- How much risk are you willing to accept? If you can tolerate fluctuations in interest rates, a HELOC may be a better fit. If you value predictability and want a fixed monthly payment, a home equity loan may be a better fit. Consider how reliable the income from the property is (assuming you use that income to pay down the debt). Would you be able to cover a significant increase in your payments?
- What are your long-term financial goals? If you’re investing in real estate with the goal of eventually selling it, a HELOC may be preferable as it allows you to maintain a fair amount of cash flow freedom. Keep in mind that if the property changes hands, both the HELOC and the home equity loan will need to be paid off in full.
How to Buy an Investment Property with a Mortgage or HELOC
You can use the mortgage proceeds however you like, including repairing and renovating the property you used to secure the loan, or even purchasing another rental or investment property.
Assuming you can get another mortgage, you could also use the loan proceeds toward your down payment. But when you factor in a mortgage, this strategy can be tricky, especially since lenders will look at your total debt-to-income ratio.
Generally, taking out a mortgage to buy another property works best if you use cash to fund it: Sometimes the proceeds from your mortgage or HELOC will cover the purchase price, and other times you can supplement it with other assets (investments, savings) to help you reach the amount you need.
Still, proceed with caution. As you already know from your first rental/investment property, real estate carries the risk of appreciation. If your local market is showing signs of slowing, now may not be the best time to take on additional real estate-related debt.
If you have to manage multiple rental and investment properties, as well as a mortgage, make sure your finances are in good shape.
Are there any tax benefits to using a home equity loan or HELOC on an investment property?
That could be the case, depending on how you spend the money you get from a rental or investment property mortgage.
While the funds can be used for any purpose, one of the most common uses of a mortgage is renovations. And for good reason: under current tax law, this is the only way you can deduct interest on the debt. Specifically, you must use the loan funds to “purchase, construct, or substantially improve” the property backing the debt (in this case, an investment or rental property) — that means repairs, upgrades, or purchasing adjacent land or parcels. You also have to itemize the deductions, which means more work for you or your accountant to realize the benefits.
Also, keep in mind that there is a limit to the amount you can claim under this deduction.
Joint and single filers who took out a mortgage after Dec. 15, 2017 can deduct interest on up to $750,000 worth of qualified loans, while those who file separately can deduct interest up to $375,000. Note that these thresholds apply to all home equity debt together, meaning if a married couple has a first mortgage and a home equity line on their main home and then takes out a separate mortgage on a vacation home they rent, all three debts will count toward the $750,000 limit.
What are the mortgage alternatives for rental properties?
If you need funds to renovate a rental property and don’t want to borrow against it, there are other options. Some are secured loans, and some aren’t.
Cash-out refinancing
A cash-out refinance means paying off your current mortgage with a new, larger mortgage and receiving the difference between the two mortgages in cash. The amount available to you will depend on the current value of your home and the equity you have built up in your home.
You may be able to secure a lower interest rate or renegotiate the terms of your mortgage. The downside is that your new mortgage payments will likely be higher (because your loan amount will be larger), and your home’s equity will decrease.
Furthermore, because a mortgage is secured by your home, if you convert your home equity into cash to buy another property, you run the risk of losing your home if you default on your mortgage payments.
Unsecured Personal Loans
If you don’t have enough equity in your home, consider a personal loan. You might not be able to set aside enough cash to buy a home outright, but you might have enough for a sizable down payment. If you qualify, you might be able to borrow up to $100,000 from a credit union, bank, or online lender.
Of course, you’ll have to pay interest on your monthly payments, but if you can buy a rental property and earn passive income from it, you might be able to pay off the loan with rental income. These types of loans don’t require collateral, but you’ll need good credit (a credit score of 750 or higher) to get the best interest rates. In addition, lenders may look at your income and assets. Your debt-to-income ratio (DTI) should be below 36 percent. The lower the better.
Bridge Loan
Hard money loans (also called bridge loans) can help you raise cash for a rental or investment property. They have more flexible credit score and debt-to-income ratio requirements, but you still need to own at least 15 percent of the home. They’re short-term loans meant to “bridge” the transition period until you can secure more permanent financing.
Therefore, it’s important to have a repayment plan in place, as these loans generally only have a repayment term of six months to a year. Also, be prepared to pay higher interest rates, upfront fees, or a larger lump sum payment at the end than with a traditional mortgage.
The final conclusion regarding mortgages for investment properties
Can you get a mortgage on a rental property or other investment property? Maybe you can. But should you? It depends.
Home equity gives you the option to buy or upgrade an investment property you couldn’t afford otherwise. However, it’s difficult to secure a home equity loan on a rental property. The loans usually come with higher costs and stricter requirements on credit scores, debt-to-income ratios, and cash reserves.
You’re also taking on some risk. Like a mortgage, when you borrow against the equity in your home, you risk losing the property if you don’t make your payments. Plus, if the building declines in value due to an economic downturn or other decline in property values, you could lose money on it. If your loan is for a home you plan to live in for the long term, going “underwater” isn’t a big deal. But if you own a property for business reasons, it’s a different story.
“You run the risk of borrowing more than the property is worth,” says Dick Leple, senior loan officer at Realfinity, a digital mortgage broker based in Pleasant Hill, Calif. “And that could make it very difficult to sell the property.”
Frequently asked questions about mortgages for rental properties
Additional reporting by Linda Bell
