What To Know Before Getting a Home Equity Loan on a Rental Property
If you own a rental property, you already know it’s a great source of passive income. But could you utilize it to build greater wealth by getting a home equity loan on a rental property? Tapping into the equity of a non-primary residence can be an important part of your financial strategy. With the right situation and guidance, you can use the best home equity loans to protect your investment or increase your profits.
Can you get a home equity loan on a rental property?
You can get a home equity loan on a rental property if you satisfy certain requirements, such as having enough equity in the property and a good credit history. Tapping into the equity of your investment property can be part of a wider investment and wealth-building process.
However, you’ll have to do the calculations to see if a home equity loan on your rental property is the best way to access extra funds. You need to be in a position to repay the loan and also have a concrete plan for using the sum you receive. As we’ll see further on, just because you can get a home equity loan on a rental property doesn’t automatically mean you should.
Factors to consider before applying for a rental property home equity loan
Before committing to a home equity loan on your rental property, make sure you understand the individual factors and implications that go into borrowing. You’ll want to make sure that you’re in the right position to handle inherent costs. Consider the following:
Your financial situation
Your financial situation will dictate whether or not you can get approved and whether or not you can afford to repay your rental property home equity loan. Lenders will check your income and credit report. Most lenders require a score of at least 700.
Your debt-to-income (DTI) ratio may also affect your ability to borrow. This DTI value shows the amount of debt you have compared to your income. Lenders often want to see a DTI of 43% or less, as this indicates enough room in your budget to take on another payment.
To repay your home equity loan, you must be prepared to make monthly payments on time in addition to your mortgage. Home equity loans also come with closing costs. You must be able to handle these additional fees on top of your new payment.
The loan amount that you need
The value of the home and the equity you’ve put in will directly dictate the dollar amount of the loan you can receive. You likely will face a percentage cap on total withdrawable equity, such as 85%, if you have paid the home off completely already.
The loan-to-value (LTV) ratio is also an important concept. Your LTV is the comparison of your requested loan amount to the property’s appraised value. Some lenders may have limited LTV caps for investment properties, such as 60%.
In addition, some banks may have caps on the dollar amount available for rental properties, such as a $100,000 total. These may be less than the amount offered for traditional home equity loans, which can be several hundred thousand. Verify with your lender what they may offer for non-primary residences before applying.
Loan terms and conditions
Investment property home equity loans typically come at a fixed rate. They may be offered for terms of 5 to 30 years in length. You may be able to find a loan with no pre-payment penalty. However, the interest rate may be higher on a home equity loan for a rental property.
Tax implications of rental property home equity loans
The interest you pay on your rental property home equity loan may be tax deductible, which can help reduce your taxable income. However, to qualify for this tax deduction you must use the loan to improve the property. In addition, you cannot rent out the property during that tax year, and you must designate the property as a qualified residence on your tax return.
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Alternative funding sources available
If you’re looking for alternative funding sources to the home equity loan, you may wish to consider these other options:
- Home equity line of credit (HELOC): Another alternative to tap into your home equity is a home equity line of credit. While a home equity loan gives you a lump sum borrowed against your equity, a HELOC is a line of credit you may charge against up to your limit as needed. You then pay it back, similar to how a credit card works.
- Cash-out refinance: A cash-out refinance allows you to take back some of the money you’ve paid into a mortgage and then refinance the greater amount you now owe. This may be a simpler process than a home equity loan because it involves a single payment, whereas a home equity loan requires you to make regular loan payments on top of mortgage payments.
- Personal loan: Though interest rates on unsecured debt such as a personal loan are often higher than rates on secured debt such as a home equity loan, they may be preferable for those who don’t wish to place their investment property in danger of potential foreclosure.
The benefits of getting a home equity loan on a rental property
Rental properties are a solid investment on their own, but the financial leverage they provide to further your wealth-building is another ballgame. Benefits associated with taking out a home equity loan for one of these investment properties include accessing funds for improvements, diversifying investments and retaining ownership of your property even when other opportunities arise.
Accessing funds for improvement projects
One of the main reasons landlords may seek a home equity loan on a rental property is to access funds for improvement projects. Since it is an investment property, many landlords don’t wish to spend extra money on their rental property. So when you need to make improvements on the property, borrowing against its equity may be one of the best options.
Diversifying your investment portfolio
If you’d like to diversify your investment portfolio, drawing on your home equity to fund your investments can be a great way to do so. A home equity loan at a lower interest rate than the estimated rate of return on your investments can be a strategic way to make investment gains without having to save for the upfront costs. You may even choose to use these funds to help purchase more property.
Retaining ownership of your investment property
If you want to purchase another home, but wish to retain ownership of your investment property, consider using a home equity loan for a down payment on a new property. This permits you to continue receiving the benefits of an investment property while freeing up the capital to make other financial moves.
Eligibility criteria for home equity loans on rental properties
When lenders evaluate your eligibility for home equity loans on a rental property, there are some ballpark numbers they’ll want to see. While this is not a hard-and-fast assessment, these values generally give a good indication that you will qualify for a home equity loan on a rental property.
- 15% to 20% equity minimum: To be eligible for a home equity loan on a rental property, many lenders will want to see that you already have equity of at least 15% to 20% in the home.
- Credit score of 620 to 700 minimum: Many banks prefer to lend to borrowers with credit scores of at least 700. There may be some flexibility with scores as low as 620, depending on other requirements.
- DTI ratio of 43% to 50% maximum: Generally, it’s best for borrowers to demonstrate a DTI ratio of 43% or less, but some lenders may be able to work with up to 50%.
How to apply for a home equity loan on rental property
To apply for a home equity loan on your rental property, you’ll need to contact lenders directly and use their approved application methods. For many lenders, this is simply an online form.
These forms will request information such as:
- Desired loan amount
- Loan purpose
- Property information, including address and building style
- Borrower identifying information, including address, contact information, birth date and Social Security Number
- Borrower income
- Borrower demographics
- Borrower credit report
Be prepared to provide documents such as:
- Driver’s license or government-issued photo identification
- Utility bills to confirm current address
- Current mortgage billing statement
- Property tax bill
- Recent pay stubs
- Two-year W-2 forms
- Tax filings
Is home equity loan interest tax deductible for a rental property?
Home equity loans are tax deductible but not usually for rental properties. The tax deduction applies only to “qualified residences” for tax years 2018 to 2025. And to deduct the interest, you must use the home equity loan for something related to the property, such as renovations.
The catch here for rental properties is that they are not qualified residences while being rented. A qualified residence is either the taxpayer’s main home or a second home designated as a qualified residence. If the home is not rented at all or not rented for that tax year, it may qualify and permit you to deduct home equity loan interest for related renovations or improvements.
Summary of Money’s what to know before getting a home equity loan on rental property
It’s possible to get a home equity loan on a rental property, but it’s important to understand the terms and conditions of these loans as well as your own financial situation before applying. Rental property home equity loans may have lower caps on the amounts you can borrow compared to primary home loans. But you’ll need to meet the same high standards when it comes to your equity amount, credit score and DTI.
If you qualify, a home equity loan on an investment property can open new doors for you to access funds for repairs, diversify your investments and retain ownership of the property. Make sure to shop around for lenders and rates and review the potential tax implications before applying for the best home equity loans so that you can be clear on benefits and challenges before taking on a home equity loan for your rental property.