Using Home Equity to Buy an Investment Property
Real estate investing is enticing because of the dream of a passive income stream with strong returns. However, there are often some big barriers in the way — like the huge pile of cash needed for a down payment on a new property.
But if you’re a homeowner, you might already be sitting on the pot of gold you need: your home equity. We’ll guide you through the process of using home equity to buy an investment property, whether that’s a rental property or a second home.
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What is equity in a home?
Home equity is the part of your home that you already own outright or, put another way, the difference between your home’s value and what you still owe on your mortgage. But did you know that you can pull from your home equity to invest and grow your money elsewhere?
For example, let’s say you have a home worth $425,000 and still owe $275,000 on your mortgage. Subtracting 275,000 from 425,000 calculates that you have $150,000 in home equity.
The only catch is that, if you want to convert that equity to cash, you can’t usually access 100% of it. Instead, you’ll typically be limited to an 80% to 85% loan-to-value (LTV) ratio, so take that into account when considering what kind of investments you might want to pursue.
Do you want to calculate how much you’ll be able to borrow with a home equity loan or HELOC? Try LendingTree’s home equity loan calculator.
Loan options when using home equity to buy an investment property
There are three main loan options to consider when you want to convert your home equity into cash.
→ A cash-out refinance lets you replace your current home loan with a new mortgage.
→ Home equity loans and home equity lines of credit (HELOCs), on the other hand, are known as second mortgages — this means that they’re still secured by your home, but don’t replace your primary mortgage.
|Cash-out refinance||HELOC||Home equity loan|
|Interest rates||Fixed or variable||Variable||Fixed|
|Interest rate competitiveness||Lower than HELOCs and home equity loans||Higher than cash-out refinances, lower than home equity loans||More expensive than other equity-tapping loans, but cheaper than personal loans or credit cards|
|How much equity can you access under standard guidelines?||80%||85%||85%|
|Good for…||Those who can benefit from replacing their existing mortgage with a new loan||Making multiple purchases or landing the lowest monthly payments possible (in the draw period only)||A single big purchase or a borrower looking for a fixed-rate second mortgage|
A cash-out refinance is when you pay off your existing mortgage by taking out a new loan for a higher amount than you currently owe. You’ll then pocket the difference in cash, which you can use as a down payment on an investment property or invest elsewhere.
Advantages: You’ll get the lowest interest rates with this option.
Drawbacks: You’ll have to pay cash-out refinance closing costs and the cash payout will increase your overall debt burden.
Beginning May 1, 2023, conventional cash-out refinances got more expensive. Expect to see higher interest rates or an extra fee at closing if you’re taking cash out and borrowing more than 30% of your home’s value.
Another option for tapping equity is a home equity line of credit or HELOC. A bit like a credit card, a HELOC is a line of credit that remains open and available during a set draw period. Unlike a credit card, however, in many cases you’ll be allowed to make interest-only payments — meaning that you won’t have to pay down the principal balance at all if you don’t want to. Once the draw period ends, though, you’ll have to begin repaying the balance and interest charges in full.
Advantages: You can use the line of credit over and over, which is helpful if you want to make multiple purchases. Plus, interest-only payments can allow for very low payments during the draw period.
Drawbacks: You’re going to have a variable interest rate, which can be stressful for borrowers who prefer the stability of a fixed-rate loan. This stress can also be exacerbated by monthly payments that jump up — often doubling — once the HELOC draw period ends.
Home equity loan
Lastly, there’s the home equity loan, a different type of second mortgage that allows you to receive a lump sum and repay the loan in monthly installments. Loan terms generally range from five to 30 years in length, and you’re likely to be offered lower interest rates with a home equity loan than you would find with an unsecured personal loan or credit card.
Advantages: You’ll have a fixed interest rate and consistent payments without having to touch your primary mortgage.
Drawbacks: You’ll receive the full payout in a lump sum whether you end up needing it all or not. And if you do take out more than you end up needing, you’ll be paying more interest and draining more of your equity than is necessary to boot.
Available only to borrowers who are age 62 or older, these mortgages are called “reverse” because you don’t have to make any payments to the lender — instead, the lender makes payments out to you. This can be a great way to convert your home equity into cash, but the most common reverse mortgage, called a Home Equity Conversion Mortgage (HECM), doesn’t allow you to use the proceeds from the loan to buy a home that won’t be your primary residence.
Investment property vs. second home: What to know
It’s common to use “investment property” in everyday language to mean any home purchased after your primary residence. However, there are important differences between rental properties, vacation homes and second homes that have implications for the loan programs you’ll qualify for.
An investment property is a home that you use to turn a profit, either through renting, appreciation or tax benefits. An investment property isn’t allowed to be your primary residence and, for tax purposes, may not be used for your personal purposes for more than 14 days a year or for more than 10% of the time it’s rented out per year.
Investment property mortgage loans are:
- Harder to qualify for than a primary residence home loan, as you’ll need to come up with a 20% to 25% down payment and have at least a 700 credit score
- Investment property interest rates are typically around 0.5% to 0.875% higher than loans on primary residences
Fannie Mae has reduced the fees it will charge for some borrowers using conventional loans to finance investment properties. Specifically, the changes affect those who are able to make between a 30% and 40% down payment on an investment property. For properties with two to four units, the decrease is for all borrowers across the board, regardless of loan-to-value ratio.
A second home, also known as a vacation home, is a property that you use primarily for your own personal purposes. It could be a beach house, an apartment in the city or a cabin in the woods — but it can’t be your primary residence or a home that you’ve purchased because it’ll earn you an income.
Second-home mortgage loans are:
- Easier to qualify for than investment property loans, since you’ll only need 10% down and a credit score in the ballpark of 620 (exact requirements will vary by lender).
- Usually going to have lower interest rates than investment property loans.
- Often going to require that a second home be located at least 50 miles away from your primary residence.
Six strategies for an investment property purchased using equity
Here are some common real estate investing strategies that make sense for someone who’s using equity to jump-start an investment.
- Use your home equity for the down payment. As discussed above, you can draw from your equity to get a down payment for a second home or investment property.
- “House hacking.” This is when you use an investment property loan to finance a home you both live in and draw a rental income from. Combining investment properties and your primary residence is usually not allowed, but a few government loan programs allow you to “house hack” as long as you live in one of the units.
With an FHA loan backed by the Federal Housing Administration, you’ll be able to put only 3.5% down and live in one unit while renting out the rest. If you’re a veteran or active-duty servicemember who qualifies for a VA loan backed by the U.S. Department of Veterans Affairs (VA), you’ll also have the option to purchase a multiunit property with 0% down. As with an FHA loan, you’re required to live in one of the units.
- “House flipping.” “Flipping” a house simply means to buy it with the intention of renovating it and then selling it at a profit. Houses that aren’t in the best shape often come with low sale prices, which leaves a wider window for profit-making once they’re sold. Renovation loans can help fund the repairs, but using home equity instead could get you a better interest rate.
- Purchase a foreclosed home. With foreclosures up 10% since last year, there’s a lot of opportunity to buy a foreclosed home at rock-bottom prices. If you use home equity to fund the needed repairs, you’re in a strong position to sell a home like this at a respectable profit.
- Real estate investment trusts (REITs). A REIT allows you to own property with as many others as you’d like and, in some cases, to own only fractional shares of a property that you don’t have to purchase, manage or maintain. Just join the REIT, and you’re in!
- Use equity from one investment property to buy another. If you already have an investment property, you can use the equity in that property to start the process all over again. Just keep in mind that you’re tying both properties together, so if the first property doesn’t do as well as you hoped, a domino effect could kick in and take both into foreclosure.
Alternative ways to finance an investment property
Don’t have enough equity to make any of the equity-tapping loan options we’ve discussed work? That’s okay. Here are some other ways to get the money you need to buy an investment property:
- Personal loan. A personal loan that won’t put your home at risk isn’t always a bad thing, and can be a far simpler prospect than a first or second mortgage.
- Hard money loan. Hard money loans are short-term loans (typically one to five years). They can come with high APRs, but they may offer something you won’t find with any other loan type: no credit check and the ability to secure the loan with a variety of property types, from cars to machinery or other valuables like precious metals.
- Person-to-person (P2P) loan. Also known as peer-to-peer loans, these are loans that you’ll access through an online platform. P2P loan platforms match people who need a loan with investors who are willing to lend to them. The loan terms you’ll find can vary widely, so make sure to do your due diligence and carefully read the fine print before applying for a P2P loan.
Looking for the best home equity lender? Look no further than LendingTree’s list of the Best Home Equity Lenders of 2023, featuring full reviews for each lender, star ratings and more.