Can You Get Home Equity Loans On Rental Property?

If you own a rental property and you have some equity built up in the home, you might be wondering if you can take out a home equity loan like you can with your primary residence. The answer is that yes, you can, but you should be aware of some of the challenges with this type of loan.

Read on to learn more about home equity loans on investment properties, the advantages and disadvantages of these types of loans, and the barriers you might face when seeking loan approval. First, a quick refresher on what home equity is and a couple of ways you can borrow against it.

What home equity means

Your home’s equity is the difference between what you owe on your mortgage and what the current value of your home is. So if your house is worth $300,000 and you owe $200,000 on your mortgage, you have $100,000 in home equity.

Every time you make a mortgage payment or your house increases in value, you build more equity. Lenders typically want homeowners to have around 20% equity in the primary residence to qualify for a home equity loan. For investment properties, lenders may require you to have even more equity in the property.

You can borrow against your equity in two ways: a home equity loan and a home equity line of credit (HELOC).

1. A home equity loan is when you borrow a lump sum of money against your home’s equity, using the property as collateral. You pay the money back at a fixed interest rate with fixed monthly payments. That means you’ll always have the same interest rate and your monthly payment will remain consistent.
2. A home equity line of credit (HELOC) is similar in that it borrows against the equity in the home. However, this option acts as a revolving line of credit like a credit card, allowing you to withdraw money over time as you need it. HELOCs usually come with variable interest rates, so your monthly payments can change. That said, you’re only required to pay interest on the money you borrow during the draw period.

Can you get home equity loans on a rental property?

If you have equity built up in your rental property, you can take out a home equity loan (or a HELOC) and use the money for whatever you choose. Common uses for home equity funds include making home improvements, consolidating high-interest debt, paying for college, or using it as a down payment on a new investment property.

It can, however, be a little more difficult for investment property owners to qualify for home equity loans on rental property, primarily because of the higher risk for lenders. For one thing, it’s riskier for your bank or credit union because you’re taking out a second mortgage on your rental property.

That means rental property owners with a home equity loan are essentially making three mortgage payments a month (assuming your primary residence still has a mortgage).

Most lenders know that in times of financial crisis, primary residences will take priority over investment properties. This means they’re most likely going to demand more stringent credit requirements to approve you for the home equity loan or line of credit.

As the owner of the rental home, it’s also important to carefully evaluate your own risks. This is especially true if you’re using the funds to purchase another investment property, points out Adie Kriegstein, a licensed real estate salesperson and founder of the NYC Experience Team at Compass Real Estate.

“One needs to carefully examine their financial situation and goals while understanding the risks and potential rewards of the investment,” she says. “Will the purchase generate enough income to cover the cost of the loan and associated property expenses? Remember that a home equity loan is secured by your property, which means that if you are unable to repay the loan, you could risk losing your home.”

General requirements for home equity loans on investment properties

There’s no denying that leveraging the equity in your rental properties is a solid strategy to maximize your return on investment potential. If you use it to buy another rental property, for example, you can earn more passive income. But it will take some time compared to other options, and you’ll need to undergo a fairly rigorous approval process.

Appraisal

Because you’re putting up your property as collateral for a home equity loan, you’ll need to have an appraisal so your lender can verify the value of your property. This helps the lender figure out how much money they’re willing to lend you.

You probably can’t get a home equity loan or line of credit if you don’t have enough equity in the property — many lenders want to see at least 20% in equity.

Loan-to-value ratio (LTV)

The appraisal helps the lender determine your LTV, which is the remaining balance of your mortgage divided by the appraised value of the property. A loan officer that deals in home equity loans on investment properties will probably require an LTV of 80% or less.

Credit history

Any type of lending requires a credit check, but due to the higher risk of a home equity loan on an investment property, you’ll likely need to have a better credit score than was required for the current mortgage.

If your credit score is anything less than 700, a reputable lender probably won’t approve the loan. And keep in mind that the higher the credit score, the better interest rates and loan terms you can qualify for.

Debt-to-income ratio

Your debt-to-income ratio (DTI) is the amount of your total monthly debt payments divided by your monthly gross income. When you apply for a primary mortgage, the cut-off for most lenders is usually around a maximum DTI ratio of 43%.

For a home equity loan on an investment property, lenders will probably want to see a DTI of less than 40%.

Cash reserves

Again, because of the added risk of loans taken out on rental properties, lenders want to see that you have plenty of money in your cash reserves to cover expenses (e.g., your loan payments) in the event of an emergency. You’ll probably have to prove that you have enough money in your cash reserves to cover expenses for up to a year or more.

Paperwork

It’s a good idea to have all your paperwork in order to smooth the approval process. The lender will want to verify your income through pay stubs, W-2s, and taxes.

Plus, you’ll likely need to provide your mortgage statements from all properties and possibly any lease agreements proving your earnings from renters.

Pros and cons of home equity loans on rental properties

Even if you have a lot of equity built up in your property, make sure you consider both the benefits and risks of a home equity loan before applying for one.

Tax benefits of a home equity loan

As you’re probably aware, homeowners can take a tax deduction on the interest paid on a primary mortgage. Home equity loans work a little differently, however. With a home equity loan, your mortgage interest is only tax deductible if the loan proceeds are used to “buy, build, or substantially improve” the property, according to the IRS.

So if you’re using the money for college tuition, to consolidate credit card debt, or pay for a wedding, you can’t deduct the interest on your taxes. Furthermore, if you use only some of the funds to pay for home improvements, only the interest on that portion of the loan is eligible for a tax deduction.

Alternatives to home equity loans and HELOCs

With some of the challenges that come with getting a home equity loan or line of credit on investment properties, it’s not a bad idea to explore some alternative options to finance your project or new investment property.

Home equity agreements

If you don’t want another monthly payment or can’t qualify for a home equity loan, a home equity agreement could be a great choice for you. This option involves selling off some of the future equity in your home for a one-time lump sum payment. And you only have to pay it back when the contract is up or you sell the property.

Personal loans

Since a personal loan is an unsecured loan, it’ll likely come with a higher interest rate than secured loans. You also may not be able to borrow as much money as you could with a home equity loan. But on the plus side, personal loans are relatively quick to qualify for, and you won’t have to pay closing costs or risk your rental property as collateral

A personal loan might be a solid option if your goal is to fix up the investment property to sell. With this option, you can also command more passive income from it. For example, if you want to spruce it up to use as an Airbnb as opposed to a long-term rental, the extra rental income you make could be enough to pay off that personal loan relatively quickly.

If you can manage to pay the loan off early, higher interest rates might not be a problem for you. Just be sure to check with your lender (before signing) to make sure there are no fees for early repayment of the loan.

Cash-out refinance

A cash-out refinance is when you literally “cash out” the equity from your home and replace your current mortgage with an entirely new mortgage. You receive the equity as a lump sum payment and the “loan” is rolled back into the new mortgage.

The nice thing about a cash-out refinance is you only have one monthly mortgage payment to budget for. On the other hand, if your original mortgage was locked in at a low interest rate, you might be reluctant to refinance at a (possibly) higher rate. But if you can get a lower rate — or one that’s similar to what you already have — a cash-out refinance might be a good strategy for you.

Credit card

As you know, credit cards typically have the highest interest rates of any borrowing option, but depending on your goals and your timeline, they have their purpose. For example, if you’re looking for a short-term loan that you can access quickly and plan to pay back in a relatively short period of time, using a credit card isn’t a horrible idea.

This could be an especially smart move if you qualify for a credit card with a 0% introductory rate. Credit cards are extremely competitive these days and you could get the introductory rate for up to 18 months — or sometimes longer.

If you can turn around your investment property quickly or earn more rental income from it, you’re looking at an interest-free loan for a year and a half. That’s a very good deal, as long as you pay it back before the high interest kicks in.