Many lenders and loan programs frown upon investment properties. Lenders do not want to stick their necks out for a property that may turn out to be a failure for you. Rather than settling for high-priced financing, you have the option to use the home equity in your primary residence to help you purchase a rental property.
How much Home Equity do you Have?
You must start with figuring out how much home equity you have. The formula is simple:
The current value of your home – the current outstanding principal balance of your mortgage(s)
For example, if your home is worth $300,000 and you owe $100,000 on your current mortgage, you have $200,000 in equity in your home. That money is yours to do with what you want. Of course, you have to tap into it with a home equity loan in order to get it, but you can take the money out and use it for a down payment on a rental property or even pay for another property in cash.
Figuring out what you Can Use
Generally, you will not be able to take out 100% of your home equity. Most loan programs limit borrowers to 80% of the value of their home. In the above example, this would mean that you could have a maximum of $240,000 in outstanding mortgages. Since you have $100,000 in a first mortgage already outstanding, that leaves $140,000 available for a home equity loan.
Determine your Next Step
The next step is to determine how much you plan to spend on your investment property. Will you pay cash, meaning you will only purchase a rental property that fits into the amount of equity you have available from your line of credit? Or will you use your equity as the down payment and secure a mortgage on the investment property for the remaining amount? Essentially, this way you do not have to put any of your own cash into the investment, but that can get risky as you now have 3 mortgages to pay: your current first mortgage on your principal residence, the new home equity loan on your primary residence and the mortgage on the investment property. If your investment falls through, meaning you do not find renters to occupy the property and pay you on time, you could end up in a financial disaster.
How to Secure the Equity from your Home
There are several ways for you to obtain the equity you have in your home:
- Cash-out refinance on your primary loan
- Home equity loan
- Home equity line of credit
The ability to receive a cash-out refinance on your primary loan depends on the program you intend to use. Typically, conventional and government-backed loans will not allow cash-out in excess of 80% of the value of the home, but some FHA lenders can go as 85%. In this type of refinance, you receive the cash in hand at the closing and do with it what you desire. Whether you put the entire amount down on a home or you put it in a savings account, you have to make full principal and interest payments on the loan right away.
A home equity loan or line of credit are separate from your primary loan. The difference between the two is as follows:
- A home equity loan provides you with the entire amount of cash up front. It works in much the same way as a cash-out refinance with the exception that it is a separate loan that you make separate payments on, which means principal and interest payments on the full amount.
- A home equity line of credit provides you with access to your equity in a separate account. The main difference with this type of loan is that you do not make full principal and interest payments on the full amount of equity. You only pay interest on the money you withdraw to use on your rental property or whatever other use you have for it. This occurs for 10 years and is called the draw period. At the end of the 10 years, you cannot draw on the funds anymore and you must start paying back principal and interest for the remainder of the term.
Benefits of Tapping into your Equity to Buy a Rental Property
There are many benefits to tapping into your equity on your primary home in order to buy a rental property:
- The interest rates on investment properties are usually pretty high, which can make it a costly investment for you
- Home equity loans have more favorable terms than investment property loans
- The closing costs are usually lower for home equity loans or even cash-out refinances
Lenders often look at any type of equity loan as a much lower risk than providing a loan on an investment property. Once you have “skin in the game” on an investment property, lenders provide much more favorable terms because you are less likely to walk away from the property if your investment fails.
Another advantage of having the cash in hand to purchase a rental property is the benefits you provide the seller. If you do not have a finance contingency on your sales contract, you might have more room for negotiation with the seller. This could mean more profit for you on the purchase of an investment property in the long run.
If you wish to purchase a rental property, consider tapping into the equity of your home to pay for it. If you did your research and know the area is profitable and has many potential renters, then you stand to make a decent profit without worrying about another mortgage aside from the home equity loan. With the lower interest rates and costs, it can be the least costly way to start your venture into investment home ownership.