A home equity line of credit (HELOC) on an investment property involves borrowing against real estate that generates income or financial returns. Unlike borrowing against a primary residence, where you reside, a HELOC on an investment property uses non-primary residential property as collateral for borrowing funds.
Although there has been increased interest in HELOCs in recent years, particularly for leveraging homeownership stakes, HELOCs on investment properties are less common and not as readily available. The majority of HELOCs are secured against primary residences, as lenders feel more secure with loans tied to the borrower’s primary dwelling, knowing they prioritize repayment of this debt.
Nevertheless, some lenders do offer HELOCs on investment properties. Understanding how these loans function and assessing whether they align with your financial objectives is crucial in determining if they are a suitable financing option for you.
How do you get a HELOC on an investment property?
Let’s start by defining our terms. An investment property refers to real estate acquired and held with the intention of generating a financial return, rather than being occupied by the owner. Such properties can encompass commercial, industrial, or residential assets. Examples of investment properties commonly owned by individuals (who are not professional real estate agents) include vacation homes, condominiums, duplexes, small apartment complexes, and accessory dwelling units (ADUs).
Obtaining a home equity line of credit (HELOC) shares similarities with securing a mortgage (indeed, HELOCs are a form of second mortgage). The process of opening a HELOC on an investment property closely resembles that of opening one on your primary residence. In both scenarios, the property serves as collateral for the debt. Here’s how the process unfolds.
1. Know your finances
Before initiating your application for a home equity line of credit, it’s essential to estimate the amount of equity you possess. Although property values have seen continued growth this year, albeit at a slower pace than during the peak of the pandemic, it’s crucial to gauge the current worth of your property in relation to the outstanding balance on your first mortgage, if any. The disparity between your remaining debt and the fair market value of the investment property approximately represents your equity stake. To assess this value accurately, you may consider seeking advice from a real estate specialist familiar with properties akin to yours to provide a broker price opinion.
2. Shop around to find the best deal
When seeking a HELOC for an investment property, your options may be more constrained compared to traditional residence-based HELOCs. Despite this limitation, it’s crucial to explore various lenders to ensure you make an informed decision. Aim to consider at least three lenders and assess their expertise in providing HELOCs for investment properties. Evaluate the APR offered by each lender and meticulously review the terms and conditions to identify any potential additional fees, such as penalties for early closure of the line of credit.
3. Apply
When it comes time to formally apply for a HELOC, expect to undergo a thorough financial assessment similar to what you would experience with any significant loan application. Lenders will meticulously review your credit score, existing debts, cash flow, reserves, and other financial particulars to assess both your eligibility for the loan and the terms of borrowing. Additionally, the lender may conduct an appraisal of your property to establish its official value. This appraisal considers factors such as the property’s condition and the type and amount of income it generates.
4. Close
Finalizing a HELOC usually proceeds much more swiftly than closing on a standard mortgage. Certain lenders can complete the process in as little as three days, allowing you to access the funds within a week.
What are the pros and cons of getting a HELOC on an investment property?
Pros
- Cost-effective borrowing option: HELOCs generally offer lower interest rates compared to credit cards and personal loans, making them a more affordable financing option. While rates may be slightly higher for HELOCs tied to investment properties, they still tend to be cheaper than business or commercial property loans.
- Reduced personal risk: Opting for a HELOC on an investment property may feel less risky than one on your primary residence. If you default on the line of credit, your primary residence remains safe from foreclosure.
- Flexible access to funds: HELOCs allow you to access funds throughout the initial draw period, making them suitable for fluctuating or long-term expenses like home renovations.
- Lower initial payments: During the draw period, you’re typically only required to pay interest, with principal repayment commencing in the repayment period.
Cons
- Limited availability: HELOCs for investment properties are not widely offered by lenders.
- Higher interest rates: Due to the increased risk associated with investment properties, lenders typically impose higher interest rates on HELOCs for such properties. For instance, TD Bank’s lowest available APR for HELOCs on investment properties is nearly 2 percentage points higher than those for primary or secondary residences.
- Additional fees: Most HELOCs come with annual fees and early termination fees if the line is closed within the initial few years.
- Negative equity risk: Property values may depreciate, potentially resulting in negative equity where you owe more on the property than its current value.
HELOC requirements: investment properties vs. primary residences
Lenders typically impose stricter criteria for investment property HELOCs. Alongside the borrower’s creditworthiness, lenders may scrutinize the financial performance of the property itself.
| Investment properties | Primary residences | |
|---|---|---|
| Credit score minimum | Generally 700 | 650-680 |
| Debt-to-income (DTI) maximum | 43% (can depend on anticipated rental income) | 43% to 50% |
| Loan-to-value (LTV) maximum | 80% | 85% |
When is it a good idea to use a HELOC on an investment property?
Employing a HELOC on an investment property provides a convenient means to access cash that can yield returns. For instance, you could utilize the HELOC funds to acquire another property, thereby diversifying your investments without tapping into your savings. Alternatively, you might allocate the funds towards enhancing your existing property, such as renovations or expansions, thereby increasing its appeal to potential tenants and boosting its rental income. HELOCs are particularly advantageous when the funds are reinvested into real estate due to associated tax benefits (as outlined below).
Are you able to deduct a HELOC on your taxes?
One of the advantages of HELOCs is the potential for tax benefits. Interest paid on a HELOC, including one on an investment property, may be tax-deductible if the funds were used for qualifying purposes related to the property, such as construction, improvements, or repairs. This could encompass remodeling, HVAC upgrades, new construction, or acquiring adjacent land.
However, it’s essential to note that not all interest is deductible. Only the interest accrued on withdrawn funds, rather than the total line of credit, is eligible. Additionally, the maximum deduction varies depending on your filing status, allowing for up to $750,000 (for single or married filing jointly) or $375,000 (married filing separately) of combined debt interest deduction, including mortgages on your primary residence. Itemizing deductions on your tax return is also necessary to claim this benefit.
Can you use a HELOC for a down payment on an investment property?
HELOC funds offer versatile usage, including down payments on additional properties. Leveraging a HELOC from an existing investment property to acquire a second one can be a strategic move, amplifying your revenue without constraining cash flow.
However, it’s crucial to ensure sufficient property income to cover monthly payments. Reviewing the lender’s terms is also wise to confirm no restrictions on HELOC usage, as some lenders may prohibit using funds for investments, whether in real estate or other ventures.
What are the alternatives to using a HELOC on an investment property?
Cash-out refinance: This involves refinancing the loan on your investment property to a higher amount, provided you have enough equity, and receiving the difference in cash. While some real estate investors use this method to continually add new properties to their portfolio, it may not be as effective now due to higher mortgage interest rates.
HELOC on your home: If you can’t secure a line of credit on your investment property, consider obtaining a HELOC on your primary residence. However, keep in mind that your home serves as collateral, and using the funds for the investment property may negate any interest deductions.
Personal loan: Depending on your debt situation, you may qualify for an unsecured personal loan. However, interest rates can be higher, especially with lower credit scores, and repayment typically begins immediately.
Small business loan: If you’ve established a company to manage your investment property, explore small business loans or lines of credit. While interest rates may be higher than personal HELOCs, presenting a solid business plan demonstrating your real estate investment strategy can make this option viable for expanding your portfolio.
In Conclusion
Initiating a HELOC on an investment property can prove to be a shrewd financial decision, especially when the funds are earmarked for real estate endeavors. This strategy allows you to utilize the property’s value to enhance its income generation or appreciation prospects. Additionally, potential tax advantages may be within reach.
Yet, it’s important to acknowledge that a HELOC on an investment property comes with its share of drawbacks. Interest rates are typically higher compared to alternative financing options, such as HELOCs on residential properties. Moreover, stringent financial qualifications and limited lender availability are factors that necessitate careful consideration.