While there are many ways to get started with real estate investing, one thing is certain –in order to begin, you’re going to need access to capital, whether that’s your own funds or someone else’s.
Many first-time investors are under the impression that they need to pay for their investment in cash in order to get off to the best start, but this isn’t necessarily true. In some cases, financing the property traditional mortgage is the best option. For other investors, especially those who have a number of properties already –hard money loans may be another avenue worth considering. But there’s another little-known option that can be used to finance real estate investments: using equity that’s in your existing home.
If you already own your own home, you might be closer to investing than you originally thought. Instead of taking out a second mortgage, you can leverage your existing home and start investing. This can be done through either a home equity loan –or a home equity line of credit (HELOC). But while these options can be a great way to secure the funds that you need to make a down payment for rental investments, it’s important to understand the risks associated with them as well. In this article, we’ll look at the difference between a HELOC and home equity loan –and show you how you can use these loan products to get started with rental investing. We’ll also take a look at other loans that are available –see how you can find the option that’s best for you.
HELOCs and Home Equity Loans: What’s the Difference?
HELOCs and home equity loans work in a similar way –but there are a few important differences.
A home equity loan works as a fixed-term loan, one that takes all of the guesswork out of loan repayment –while a HELOC acts like a revolving line of credit –much like a credit card.
Both loans are based on the amount of equity that’s in your home –so if you’ve just taken out a mortgage on your home –and made a low down payment, these loans wouldn’t be an option. Instead, they’re available to borrowers who have accrued enough equity in their homes.
While the most common uses of HELOCs are home improvements and debt consolidation, you can use these loans for anything you’d like. This flexibility makes it an ideal way to obtain funds for an investment property. By tapping into the equity that you have in your home, and using it as a down payment to purchase your first rental, you’ll be able to get the ball rolling with your investments.
Here’s a look at both HELOCs and home equity loans now:
- Home Equity Line of Credit (HELOC)
Home equity lines of credit work in a similar way to a credit card, in that you have a line of credit that you can access.
Generally, HELOCs allow you to borrow up to 85% of your home’s value, which means you’ll need to have a significant amount of equity built up in your home first. Generally, you’ll also need good credit along with verifiable income in order to qualify.
While a home equity loan offers fixed interest rates, equity lines of credit often come with variable interest rates. This means your rates could change at any time. While interest rates have been at historical lows, they could change –and since HELOCs can last for a long time, this could mean more risk for you.
Generally, home equity lines of credit can be drawn on for ten years or so. During the draw period, you’re required to make payments –but they’re generally low, as you’re only paying the interest. Once the draw period’s ended though, and you start repaying the loan –the payments become much higher as you’re paying back the principal –and interest, often at a variable rate. This increase in payments can be a shock to some, and if they’re too high, can cause those in financial issues to default on the loan –and end up losing their home.
- Home Equity Loan
One of the main differences between a HELOC and a home equity loan is how you access your credit. HELOCs work in a similar way to a credit card, where you have an open-ended line of credit that you can access. Home equity loans, on the other hand, are usually set.
A home equity loan, sometimes referred to as a second mortgage, has fixed interest payments for a fixed term. This means there’s more certainty as to what your repayments will look like, allowing you to accurately gauge the soundness of your loan and investment.
Other Loan Options
When it comes to securing a loan, a HELOC or a home equity loan aren’t your only options; there are a few different options available. Let’s look at them now.
- A Traditional Mortgage
First up, a traditional mortgage. Some first-time investors obtain traditional financing for their investment properties, and then use a HELOC or home equity loan to help make the down payment.
Keep in mind, though, that there are more restrictions on eligibility for investment property loans than there are for your primary residence. You’ll usually need to make a 20% down payment for investment properties as well.
You should also be aware that not every lender will approve mortgages for an investment property out of state, so if you are investing outside your local market, you might have restrictions.
- A Personal Loan
While personal loans are often used for smaller purchases, there are some that will allow you to borrow up to $35,000. One benefit of using these loans is that they usually carry lower set-up costs than HELOCs. Generally though, they come with higher interest rates as well since there’s more risk with these loans as they’re not backed by an asset.
- A Cash-Out Refinance
Another loan option is a cash-out refinance, which is essentially refinancing your first mortgage. With this option, you would take out a new loan that’s bigger than your existing one, giving you access to the cash that’s leftover. If the interest rates for this loan are lower than a HELOC, you should consider using this option instead.
Qualifying for a HELOC or Home Equity Loan
While the restrictions are often less than those of a typical home mortgage, there are still things you need to consider when applying for a HELOC or home equity loan.
- Check Your Credit Score
As with most loans, your credit score plays a major role in if you will be approved for a HELOC, or the type of loan terms you’ll qualify for. In most cases, you’ll need a FICO score of at least 680 in order to be approved for a HELOC.
- Debt-to-Income (DTI) Ratio
Your debt-to-income (DTI) ratio is something else that your lender will be paying attention to. You will need to reassure them that taking out another loan (regardless of how that loan is classified) will not jeopardize your ability to make payments. In most cases, banks or lenders will calculate your debt-to-income ratio to ensure that you can afford to borrow more. Generally, you will need a DTI ratio of 43% or lower.
- Find Out How Much Equity You Have
Finally, your ability to secure a HELOC hinges on how much equity you have built up in your home. Typically you can borrow up to 85% of your home’s value in order to qualify for a HELOC, so you will need to make sure you have equity before applying. With a home equity loan, it’s a similar story. Your lender will typically want to ensure that the combined value of any loans does not exceed 80% of the home’s value.
Risks of Tapping Into Your Home’s Equity
Using your own home as leverage to get on the road to investing sounds like a foolproof plan, but as is the case with most loans, it’s important to understand the risks associated with this type of loan product.
Here’s a look at some now:
- Home Depreciation
One of the biggest risks of leveraging against your equity in your home is if your home were to suddenly decrease in value, eating into the remaining equity that you have, or even dipping below the outstanding loan balance. In this case, you could end up with an underwater mortgage –as was the case for many homeowners during the 2008/2009 housing crash. The best way to keep your risk low is to always leave at least 20-25% equity as a cushion against any sudden downturns in the housing market –something that most lenders these days will require you to do anyway.
- Difficulties Making the Repayments
If you’re unable to make your monthly payments, you will risk foreclosure on your home. For this reason, your bank will carefully assess your ability to repay the balance by requiring proof of regular income and looking closely at your DTI ratio.
- Risky Borrowing
One final risk is unwise borrowing practices. With a HELOC or home equity loan, you have the freedom to use the money for any purchase –which could make it tempting to take out a larger loan than you need, or to use the money for expenditures, rather than investments. The safest option is to always take a disciplined and goal-oriented approach with any loan; but especially one that borrows against the equity in your primary residence.
Using a HELOC can be a great option for many investors –but only if the money is invested wisely. By knowing what options are available, you can find the best solution for you –one that’ll help you to start investing sooner –allowing you to reach your long-term financial goals.
Still on the fence about rental properties? See: Why SFR Offers Long-Term Stability.
Ready to get started? Taking an informed approach is always the best start. Check out: Tips for Success From Experienced Investors –learn from others who have been there, done that before.
Note: This information in this article is intended to inform and guide. It is not meant to serve in place of advice from a professional lending agency. Loan terms vary considerably from lender to lender and depending on factors such as your credit score, DTI ratio, and more. Be sure to consult with your lender first to learn more about financing and to see what loan terms you qualify for.
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