What is a HELOC on a Rental Property?
While you may have heard of getting a home equity line of credit (HELOC) on your home, did you know that you can also secure these loans using your rental properties? By tapping into your equity, you can obtain a line of credit, ensuring you have money should a hot investment property come on the market or your current rentals need improvements.
This financial strategy, however, possesses both benefits and drawbacks. Let's see if this funding option is right for you and how you can get a HELOC on your investment property.
What is a HELOC on a rental property?
A HELOC offers a revolving line of credit, much like a credit card, only with lower interest rates. You secure this second mortgage with the equity in your rental property, using it as collateral. You may use the loan to make a down payment on a new property, fix up existing properties and for almost any other purpose.
Like a credit card, you can draw money out, repay and then use it again during the draw period. This period typically lasts about 10 years. During this time, you have the option of making interest-only payments.
Then, the repayment period begins. During this period, which can last up to 20 years, you make principal and interest payments. Most HELOCs have variable interest rates, which fluctuate based on market conditions. Some lenders allow you to convert some of the balance to a fixed rate.
What are the benefits of a HELOC on a rental property?
A HELOC on a rental property lets you tap into your equity and only use the funds when needed. The interest-only payment period gives you time to fix up properties and potentially resell them. Borrowing on an investment property also retains the equity in your primary home and doesn't put it at risk.
The following represent a few of the benefits:
- Use funds as needed: Unlike a home equity loan, a HELOC lets you draw funds as needed. Lenders also set few restrictions on how you use the money.
- Use repeatedly during the draw period: You can use this credit line, pay back funds, and then draw them out again.
- Pay interest only during the draw period: Paying interest only gives you time to fix up properties.
What are the drawbacks of a HELOC on a rental property?
Lenders consider loans on investment properties a higher risk than those on primary residences. After all, should you default, losing your home is a much greater setback than losing a rental property. Additionally, second mortgages carry greater risk because the first mortgage gets priority in getting paid off in foreclosures.
Because of this, you'll find the following drawbacks:
- Higher interest rates and fees: Lenders expect greater compensation because of the risk involved. Interest rates on HELOCs for rental properties tend to run higher than those on homes.
- Harder to qualify: You'll also find stricter requirements.
- Difficult to find lenders: Most lenders prefer lower-risk loans.
- Risk investment property: Because you're using your rental as collateral, you risk losing it to foreclosure.
How can you get a HELOC on a rental property?
Some good sources for finding a reputable lender include local credit unions and private real estate lenders. Their interest often depends on the market and the condition and desirability of your current property.
Because credit unions have a stake in the local community, they may realize the benefits of creating more rentals or upgrading existing ones. Private lenders are often real estate professionals who understand the value of growing a portfolio.
While all lenders differ, LendingTree reports that some of the typical requirements for getting a HELOC on a rental property include the following:
- Credit score: 720 to 740 or higher
- Debt-to-income ratio: Below 40% to 50% (The DTI represents the percentage of your monthly income that goes to paying your debt.)
- Loan-to-value ratio: Maximum 80% (The LVR is the property value divided by what you owe.)
- Cash reserves: Requires significant cash reserves, often 6-18 months or more.
- Tenant or property history: Steady history of income and a current tenant
Lenders will also want to see your real estate balance sheet and property income statement.
What are some alternatives to a HELOC on a rental property?
You may consider obtaining a HELOC on your primary home. The downside is that if a disruption occurs in your life and you default, it could result in losing your home. That said, a HELOC on your home offers many benefits, including lower interest rates and less stringent requirements.
As you can see from the highlights below, it's much easier to qualify for a primary home HELOC. While all lenders vary, these represent the typical requirements.
- Credit Score: 620 or higher
- Debt-to-Income Ratio: Less than 43% to 50%
- Loan-to-Value Ratio: Maximum 85%
- Cash Reserves: May not be required
- Tenant or Property History: Living in your home
Other alternatives include personal loans and credit cards. Because these are unsecured loans, they come with a higher interest rate and lower credit limit. A cash-out refinance lets you take cash out and replace your existing mortgage with a new one. However, if you locked in a lower interest rate on your current loan, this option may not make financial sense. You may also consider a home equity loan, which comes in one lump sum.
Obtaining a HELOC on your rental may offer a good opportunity to set aside money should a solid investment property come along. It's also ideal if you're fixing up a home with the intention of selling it, thanks to the interest-only payment option. However, because it's a lien against your property, it's best to consider this loan carefully and weigh your options.