A home equity line of credit (HELOC) on an investment property is a loan secured by a piece of real estate and used to generate income or financial returns. So, rather than taking out a HELOC on your primary residence, a HELOC on an investment property uses a location where you do not live as collateral to borrow money.
While many borrowers have expressed interest in HELOCs over the last two years, HELOCs on investment properties are not as widespread – or as straightforward to obtain. The great majority of HELOCs are obtained against primary residences; lenders are more comfortable with a loan against the physical roof over your head because they know you would prioritize repaying the loan.
However, some lenders do offer HELOCs on investment properties. Here’s how they work, and how to decide if they’re a good strategy for your financing needs.
How do you get a HELOC on an Investment Property?
Getting a HELOC is similar to getting a mortgage (in fact, HELOCs are a type of second mortgage). Here’s how the application process works.
1. Know your finances.
Before you apply for a home equity line of credit, you’re going to want to estimate how much equity you have. Property values have continued rising this year – albeit more slowly than they had been during the peak of the pandemic – so you’ll want to get a sense of what your property is worth versus how much, if any, you have left to pay on the first mortgage.
The difference between how much you owe and the investment property’s fair market value equals, roughly, the amount of your equity stake. In ascertaining the value, you might want to consult a real estate professional who specializes in similar properties to issue a broker price opinion on yours.
2. Shop around to find the best deal.
Shopping around for a HELOC on an investment property is going to be more limited than for the regular, residence-based variety: There simply aren’t as many lenders that offer these lines of credit. Still, there are always choices, and it’s always important to compare. Try to find at least three lenders, and try to suss out how practiced they are in this sort of HELOC. Look at the APR that each lender offers, and be sure to scrutinize the fine print to understand whether there are additional fees such as a penalty for closing the line of credit early.
3. Apply.
When you’re ready to officially apply for a HELOC, be prepared for the kind of complete under-the-hood type of financial scrutiny you would receive with any type of request to borrow a sizable chunk of money. A lender will look at your credit score, your debt load, your cash flow, your cash reserves and every other detail about your finances to determine a) whether they will loan you the cash and b) how much they’re going to charge you to borrow it.
The lender will also probably do an appraisal of your property, which sets the official value on it. In determining its worth, they’ll look at its condition and also the amount and sort of income it generates.
4. Close.
Closing on a HELOC is typically a much faster process than closing on a traditional mortgage. Some lenders will close in as little as three days, and you can access the cash within a week.
Using a HELOC on an investment property can be an easy way to access cash that will generate a return. For example, you might use the funds from the HELOC to buy another property that can act as an additional investment, without depleting your savings. Or you might use the funds to upgrade or expand your property, making it more attractive to prospective tenants and enhancing its revenue stream. HELOCs are an especially good idea when you want to use the funds on the real estate itself — especially because there are tax benefits.
Benefits of Using a HELOC for Real Estate Investment
One of the most common applications for a home equity line of credit (HELOC) is to invest in real estate. A HELOC is a revolving line of credit that lets you borrow against the equity in your home. You can use it to support property purchases, renovations, or flips. Investing in real estate can be a profitable strategy to earn passive income, accumulate wealth, and diversify your portfolio.
Read Also: Refinancing Your HELOC: When it Makes Sense to Chase Lower Rates
However, it also carries hazards and problems that you should be aware of. In this section, we’ll go over some of the advantages and disadvantages of using a HELOC for real estate investing, as well as some recommendations on how to do it successfully.
Some of the benefits of using a HELOC for real estate investment are:
1. Flexibility: A HELOC gives you the flexibility to access your funds whenever you need them, up to your credit limit. You can use it for multiple purposes, such as paying for the down payment, closing costs, repairs, or improvements of a property. You can also use it to cover any unexpected expenses or cash flow gaps that may arise during the investment process. Unlike a traditional mortgage, you don’t have to apply for a new loan every time you want to buy a property. You can simply draw from your HELOC and repay it as you wish, as long as you meet the minimum monthly payments and interest charges.
2. Affordability: A HELOC typically has a lower interest rate than other types of loans, such as personal loans, credit cards, or hard money loans. This means that you can save money on the cost of borrowing and increase your return on investment. Additionally, a HELOC may have lower fees and closing costs than a conventional mortgage, which can also reduce your upfront expenses. Furthermore, the interest you pay on a HELOC may be tax-deductible if you use it for investment purposes, depending on your tax situation and the IRS rules. You should consult a tax professional before claiming any deductions.
3. Leverage: A HELOC allows you to leverage the equity in your home to buy more properties and increase your earning potential. For example, if you have $100,000 of equity in your home and a HELOC with an 80% loan-to-value ratio, you can borrow up to $80,000 to invest in real estate. This way, you can use your existing assets to acquire new assets and create more wealth. leverage can also amplify your returns, as you can earn more income from the properties than the interest you pay on the HELOC. However, leverage also magnifies your risks, as you can lose more money if the properties decline in value or fail to generate enough income to cover the HELOC payments.
Some of the drawbacks of using a HELOC for real estate investment are:
1. Risk: Using a HELOC for real estate investment involves a high degree of risk, as you are putting your home as collateral for the loan. If you default on the HELOC payments or the lender decides to freeze or reduce your credit limit, you may lose your home to foreclosure. Moreover, if the real estate market crashes or the properties you invest in perform poorly, you may end up owing more than the value of your home and the properties combined.
This can result in a negative equity situation, where you owe more than what you own. To mitigate this risk, you should only invest in properties that you can afford to pay for, have a solid exit strategy, and monitor the market conditions and the HELOC terms closely.
2. Complexity: Using a HELOC for real estate investment can be a complex and challenging endeavor, as you need to have a good understanding of the real estate market, the HELOC terms, and the tax implications. You also need to have a clear plan and a realistic budget for each property you invest in, and be able to manage multiple projects and payments at the same time.
You may need to hire professionals, such as realtors, contractors, property managers, or accountants, to help you with the various aspects of the investment process. You should also be prepared to deal with any issues or problems that may arise, such as vacancies, repairs, maintenance, tenant disputes, legal matters, or regulatory changes.
3. Competition: Using a HELOC for real estate investment can be a competitive and time-sensitive activity, as you may face competition from other investors who are also looking for profitable properties and deals. You may have to act fast and make quick decisions to secure a property before someone else does. You may also have to bid higher or offer better terms to win a deal, which can reduce your profit margin or increase your risk. To overcome this challenge, you should do your research and due diligence, network with other investors and professionals, and look for off-market or distressed properties that have less competition and more potential.
Using a HELOC for real estate investment can be a beneficial and rewarding strategy, but it also requires careful planning, execution, and management. You should weigh the pros and cons of using a HELOC for real estate investment, and consider your goals, risk tolerance, and financial situation before making any decisions. You should also seek professional advice from a lender, a realtor, a contractor, a property manager, a tax expert, or a financial planner, as needed. By doing so, you can use a HELOC to access your home equity and invest in real estate successfully.
Repayment and Interest Rates
Managing Your HELOC: Repayment and Interest Rates is an important part of using a Home Equity Line of Credit (HELOC) to tap into your home equity and invest in real estate. In this section, we will look over the numerous factors and tactics involved in efficiently managing your HELOC.
1. Understand Your Repayment Options: When it comes to repaying your HELOC, you typically have two options: interest-only payments or principal and interest payments. Interest-only payments allow you to pay only the interest accrued on the outstanding balance, while principal and interest payments require you to pay both the interest and a portion of the principal amount. It’s important to carefully evaluate which repayment option aligns with your financial goals and capabilities.
2. Monitor interest rates: Interest rates play a significant role in managing your HELOC. As they fluctuate, it’s essential to stay informed about the current market rates and how they impact your repayment. higher interest rates can increase your monthly payments, while lower rates may provide an opportunity to save on interest costs. Regularly monitoring interest rates can help you make informed decisions regarding your HELOC.
3. Utilize Prepayment Strategies: If you have the financial means, consider implementing prepayment strategies to accelerate the repayment of your HELOC. Making additional principal payments can help reduce the overall interest costs and shorten the repayment period. By allocating extra funds towards your HELOC, you can effectively manage your debt and potentially save money in the long run.
4. Plan for Interest Rate Changes: HELOCs often come with variable interest rates, meaning they can fluctuate over time. It’s crucial to plan for potential interest rate changes and their impact on your repayment. Assess your financial situation and evaluate whether you can handle potential increases in interest rates. Having a contingency plan in place can help you navigate any future changes effectively.
5. Seek Professional Advice: Managing your HELOC can be complex, especially when it comes to repayment and interest rates. Consider consulting with a financial advisor or mortgage specialist who can provide personalized guidance based on your specific circumstances. They can help you understand the intricacies of your HELOC and assist in developing a tailored repayment strategy.
Remember, effectively managing your HELOC’s repayment and interest rates is key to maximizing the benefits of accessing your home equity for real estate investment. By understanding your options, monitoring interest rates, utilizing prepayment strategies, planning for rate changes, and seeking professional advice, you can navigate the complexities of managing your HELOC with confidence.
Potential Risks and Pitfalls of Using a HELOC for Real Estate Investment
Using a HELOC for real estate investing can be an effective strategy to leverage your home equity and produce passive income. However, there are certain potential hazards and disadvantages to consider before deciding to follow this road. In this section, we’ll go over some of the most typical obstacles and drawbacks of using a HELOC for real estate investing, as well as how to avoid or manage them. Here are some of the things to consider:
1. Interest rate risk: A HELOC is a variable-rate loan, which means that the interest rate can change over time based on the market conditions and the lender’s discretion. This can affect your monthly payments and your overall cost of borrowing. If the interest rate goes up, you may end up paying more than you expected or budgeted for. To reduce this risk, you can try to lock in a fixed rate for a portion of your HELOC balance, or refinance your HELOC to a fixed-rate loan if the rates are favorable. You can also use a HELOC calculator to estimate your payments and interest costs under different scenarios.
2. Payment shock risk: A HELOC has two phases: the draw period and the repayment period. During the draw period, you can access your credit line and make interest-only payments. During the repayment period, you have to pay back the principal and interest over a fixed term. This can cause a significant increase in your monthly payments, especially if you have a large balance or a high interest rate. To avoid this risk, you should plan ahead and budget for the repayment period. You can also try to pay down your principal during the draw period, or extend your repayment term if possible.
3. Overleveraging risk: A HELOC allows you to borrow up to a certain percentage of your home equity, usually 80% to 90%. This can give you a lot of purchasing power, but it also means that you are putting your home at risk. If you borrow too much and the value of your home or your investment property declines, you may end up owing more than your assets are worth.
This can lead to negative equity, foreclosure, or bankruptcy. To prevent this risk, you should be conservative with your borrowing and investing decisions. You should also monitor the value of your home and your investment property regularly, and adjust your strategy accordingly.
4. Tax implications: A HELOC can have some tax benefits, but it can also have some tax consequences. Depending on how you use your HELOC, the interest you pay may or may not be deductible. For example, if you use your HELOC to buy or improve your primary residence, you can deduct the interest up to a certain limit.
However, if you use your HELOC to buy or improve an investment property, you can only deduct the interest as a rental expense against your rental income. You should also be aware of the capital gains tax that you may have to pay when you sell your investment property. To optimize your tax situation, you should consult a tax professional and keep track of your HELOC usage and expenses.
