How To Use Home Equity Loans On A Rental Property

It’s challenging to locate a decent deal in today’s real estate market because of its competitive nature. Many investors would rather not miss out on a lucrative opportunity than have it go to another party. Getting a home equity loan on a rental property is one approach to having cash on hand that is ready to be used. To cover a significant expense, a property owner can take out a loan against the equity in their various holdings.

The advantages and disadvantages of using your property as collateral for a loan should be weighed carefully before deciding to obtain a home equity loan. Borrowing against the equity in either an investment or rental property is possible with a home equity loan.

How do home equity loans work?

A home equity loan is a loan secured by the borrower’s equity in their home. The term “equity” refers to the monetary surplus that a homeowner has over what is owed on their mortgage.

Before getting a home equity loan, a homeowner must have built up equity in their home. Then they can take out a loan against that equity and use the funds for things like home repairs, paying off debt, or funding further education.

In most cases, a lender would advance a lump sum of cash to a borrower, who would repay the money over a set time (usually 5-15 years) and interest rate.

Remember that the lender may foreclose on your house if you cannot keep up with your mortgage payments. Since the lender is taking on greater risk by lending money against a home that already has a mortgage, the interest rate on a home equity loan is often higher than on a primary mortgage.

How to use a home equity loan to buy a rental property

It is possible to use the equity of one’s primary residence as collateral for a loan that will be used to purchase an investment property. When people get a home equity loan to buy a rental property, they essentially use the value of their main home as security. This is especially helpful if the investment property is more expensive than the borrower’s primary house because the borrower will have access to a larger sum of money than they would with a conventional mortgage.

If you want to use a home equity loan to buy a rental property, you should follow these general rules:

Determine the equity in your primary residence

Knowing how much equity you have in your primary residence is the first step in using a home equity loan to purchase an investment property. This can be done by calculating the current market value of your home and deducting the amount still owed on your mortgage. Lenders often require equity in the principal residence of at least 20% for a home equity loan.

Research rental properties

Once you know how much equity you have, you may start looking into investment homes. The goal should be to find rental homes that can cover their own costs, such as the mortgage, after taxes, and maintenance. Remember that the lender will do their own inspection to ensure the property meets their lending standards.

Get your financial paperwork together

You’ll need to show that you can repay the loan by submitting documents such as tax returns, wage stubs, and W-2s. You must also provide recent mortgage statements for any existing property you own to prove that you have a track record of making payments on time. It is possible that you will be asked to present copies of tenant leases in addition to rental insurance documentation when securing financing for a property that will be used as an investment.

Compare lenders

The higher risk associated with investment properties means that not all lenders are willing to extend home equity loans for such purchases. Having more interviews with lenders increases your chances of discovering the best rates and terms. Some lenders may promise enticingly low-interest rates, but when added to their hefty costs, they may actually cost you more. Make sure you grasp the total price tag, which should include any additional lender or third-party fees.

Get pre-approved for a home equity loan

Once you’ve located a rental property you’d want to buy, the next step is to get pre-approved for a home equity loan. This will necessitate disclosing personal details to the lender, such as your income, credit history, and employment background. The loan amount and terms will be established based on the data provided to the lender.

Close on the rental property

To finalize the purchase of the investment property, you must first get pre-approval for a home equity loan. Loan money must be used for the actual purchase of the property. Either the lender or the title business handling the escrow can make the final distribution of monies to the seller.

Repay the loan

After making a purchase, a home equity loan is similar to any other loan in that it must be paid back over time, usually between 5 and 15 years, at a fixed interest rate. An installment payment consisting of principal and interest is due monthly to the lending institution.

Manage your rental property

If you own a rental property, your primary responsibilities will be to find tenants, maintain the building, and collect rent. Property management, upkeep, and documentation of fixes and upgrades are all things to bear in mind.

Are home equity loans on rental property tax deductible?

Interest paid on a home equity loan secured by rental property may be tax deductible depending on the property’s use of the funds. The interest on the loan is tax-deductible if the money from the equity loan is used to “buy, develop, or significantly improve” the rental property.

The interest on a home equity loan may no longer be 100% tax deductible due to recent changes in the legislation. The Tax Cuts and Jobs Act of 2017 says that the interest on home equity loans is no longer tax-deductible unless the money was used to “buy, develop, or significantly improve” the main house. In contrast, any money utilized to do something else, like pay off credit card debt, is not deductible.

If you plan on using a home equity loan to invest in rental property, you should talk to a tax expert to find out if and how much of your interest would be tax deductible.

It’s also worth noting that the total amount of debt attached to the property will determine a cap on the amount you can deduct. Furthermore, rental properties are subject to different tax rules than personal residences; therefore, it is vital to contact a tax specialist to ensure you fully understand the financial ramifications of owning a rental property before making the purchase.

The Bottom Line

By taking out a home equity loan to buy an investment property, real estate investors can avoid the time and cost of the standard mortgage process. However, before deciding to use a home equity loan for rental property acquisition, it is vital to consider issues such as equity requirements, credit score, income, repayment terms, and tax implications. 

Changes to the tax code could limit interest deductions for home equity loans to those used to “buy, develop, or significantly improve” the main home. Before using a home equity loan to pay for an investment property, you should talk to a tax expert. It’s also essential to make sure you’re capable of managing the rental property and that the income earned is sufficient to pay back the loan and meet the additional expenses that come with property ownership.