The Challenges of Using Home Equity Financing For a Rental or Investment Property

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You can get home equity loans for investment and rental properties, but you’ll face more scrutiny and higher borrowing standards when you use this financing method.

That’s because lenders view secondary properties as higher risk and will take steps to mitigate their exposure before approving a loan. That means you’ll need a stronger financial profile and more assets to meet your loan obligation.

There are also challenges with getting approved for a HELOC as a rental property owner. Requirements vary by lender, but you may need to show you can afford to repay the entire amount.

Further complicating things is that when providing proof you can repay a home equity loan or a HELOC, you can’t claim all rental income as part of your overall income.

That’s because renters may move out, and landlords may have other expenses or issues that could undermine financial stability.

Also, be aware that under current tax law, you can only claim the interest on your home equity loan as a tax deduction if you use it to “buy, build or substantially improve” the property used to secure the loan. There are caps on how much interest you can deduct, and to take advantage of this significant saving, you’ll need to itemize your deductions.

Here’s a closer look at several things that can complicate your loan approval efforts.

A Lower Loan-to-Value Ratio

A high loan-to-value ratio, or LTV, is a higher risk to a lender. An LTV ratio is calculated by dividing the amount borrowed by the property’s appraised value. This is expressed as a percentage.

For example, if you buy a home appraised at $300,000 and make a $45,000 down payment, your LTV ratio is 85%, calculated by dividing $45,000/$300,000.

On a rental property home equity loan, lenders generally want to see an LTV of 70% to 80% or less for a rental property.

A Low Debt-to-Income Ratio

While a homeowner might be allowed to have more than 40% of their income going toward debts and still be approved for a home equity loan, a rental property owner generally needs to have a lower ratio in the range of 30 to 35% of their income.

Higher Cash Reserves

Lenders want to see that you have plenty of money in your cash reserves to cover expenses and loan payments in the event of an emergency. You may need to prove that you have enough money in your cash reserves to cover expenses for up to a year or more.

Higher Interest Rate or Paying Points

Because risk is perceived as higher, lenders charge higher interest rates for a home equity loan or HELOC on a rental property. Market conditions change constantly, so it’s impossible to say what those higher interest rates will be, but you should plan on paying more for the privilege of getting a loan with higher risk attached to the collateral.

Alternatively, lenders may choose to charge you points on your loan. Points are a one time payment expressed as a percentage.

So, if you’re required to pay 2 points for the privilege of borrowing, that equates to a fee of 2% of the loan amount on a home equity loan. Another possibility is that you may be charged a higher interest rate that might be a quarter or half point more on the loan’s interest rate than you would pay for a primary residence loan. 

Higher Credit Score

Getting an equity loan on a rental property could require a credit score of 680 to 700, compared to 620 for a homeowner who lives in their home. Lenders have some leeway here, but a higher credit score is one of the factors they will consider before a loan approval.

Rental Property Insurance

Much like homeowners insurance, lenders will require you to carry enough insurance on the property you’re putting up as collateral. You’ll need to plan for this added cost, which is another risk mitigation requirement you’ll need to meet.

Caps on the Number of Rental Property Mortgages

Lenders may limit the number of rental property mortgages you can have. In the past, many lenders have limited this to 4-6 mortgages.

That is one of the questions you’ll need to ask as you shop for a home equity loan with various banks and credit unions. 

Lenders may cap the number of rental property mortgages at six, Ramnarain says. Four to six liens are possible for rental property owners, Huettner says.

Longer Appraisal Time

The waiting time to use a new appraisal, which will take into account repairs and renovations, for an investment property is typically 12 months from the date of purchase. If it’s less than 12 months from the date of purchase, the last recorded sales price will be used, which could reduce the amount of a loan you’ll qualify for.

In addition, lenders usually require two appraisals to confirm the property’s value.

Alternatives to Home Equity Loans on Rental Properties

There are other ways to finance a rental property. Some of these include the following.

Cash-out refinance

Cash-out refinancing means you pay off your primary mortgage with a new, larger one and then take the difference between the two mortgages in cash. The amount of money you can access will depend on your home’s current value and the equity built up in your home.

You can use the funds of a cash-out refinance for anything, including purchasing a rental or investment property. Your new mortgage payment will be more expensive since the loan is larger, and you will have less equity in your home.

In addition, a mortgage uses your home as collateral, so if you turn your equity into cash to buy an additional property, you risk losing your primary home if you default on your mortgage.

Unsecured personal loan

Consider a personal loan if you don’t have enough equity in your home to use it as leverage for a home equity loan.

That may not be enough to buy a house outright, but it could be enough for a sizable downpayment. Unsecured personal loans don’t require collateral but to get the best interest rates, you will need an excellent credit score of at least 750 and a debt-to-income (DTI) ratio below 36 percent.

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