If you have built substantial equity in your home, you may be considering whether to put some of that equity to work. One strategy is using a home equity loan to help purchase an investment property.
This approach can provide funds for a down payment, renovations, or potentially a larger portion of the purchase. But it also adds debt secured by your current home, so the potential investment return should be weighed carefully against the additional financial risk.
What Is a Home Equity Loan?
A home equity loan allows you to borrow against available equity in your home. Equity is generally the difference between the property's current value and the amount you owe on mortgages secured by it.
Unlike a home equity line of credit (HELOC), which provides a revolving line of credit, a home equity loan provides the proceeds as a lump sum. Home equity loans also typically have a fixed interest rate and scheduled monthly payments.
Your home serves as collateral. If you cannot repay the loan, the lender could pursue foreclosure, which makes responsible borrowing especially important when the proceeds are being used for an investment.
Can You Use a Home Equity Loan to Buy an Investment Property?
Potentially, yes. Depending on the home equity loan and the financing used for the investment property, proceeds may be available for a down payment, closing costs, improvements, or other eligible expenses.
For example, current Fannie Mae guidelines recognize borrowed funds secured by an asset, including real estate, as an acceptable source for down payment and closing costs when applicable requirements are met.
The lender financing your investment property will still need to document the source of the funds and consider the home equity loan payment when evaluating your debts and overall qualification.
How Much Home Equity Can You Borrow?
There is no universal rule that every homeowner can borrow up to a specific percentage of the property's value. Home equity loan limits vary by lender and can depend on your home's value, existing mortgage balance, credit, income, debts, occupancy, and other underwriting requirements.
A lender may require an appraisal or another acceptable property valuation to determine the home's current value and calculate the amount of equity available.
Before assuming a particular amount will be available, obtain an actual home equity loan quote based on your financial profile and property.
Why Use Home Equity for a Real Estate Investment?
The primary advantage is access to funds you have accumulated through homeownership without selling your current property. Receiving the proceeds as a lump sum can also make budgeting for an investment property purchase or renovation easier.
Using home equity may allow you to make a larger down payment on the investment property, which reduces the amount that needs to be financed through the investment property mortgage.
However, borrowing against your home does not make an investment property less expensive. You are adding another debt payment that needs to be considered when calculating the investment's overall cash flow.
Calculate Rental Property Cash Flow Carefully
Expected rent should never be compared only with the investment property's mortgage payment. A realistic analysis should account for the full cost of owning both the investment and the additional home equity debt.
Potential expenses can include:
- Investment property mortgage payments
- Home equity loan payments
- Property taxes
- Landlord and applicable flood insurance
- HOA or condo fees
- Repairs and maintenance
- Vacancy periods
- Property management
- Major replacements and unexpected expenses
Rental income can change, and vacancies or major repairs can occur unexpectedly. Maintaining appropriate cash reserves can help you continue making required payments when the property is not producing the income you anticipated.
Understand the Risks of Using Your Home Equity
The most significant consideration is that you are putting equity in your existing home at risk to finance an investment.
If the rental property underperforms, you still owe the home equity loan. A decline in property values could also leave you with less equity than expected, while repairs, vacancies, insurance increases, or other expenses could reduce investment returns.
Before borrowing, consider whether you could comfortably make payments on both properties without depending on uninterrupted rental income.
Is Home Equity Loan Interest Tax Deductible?
Tax treatment depends heavily on how borrowed funds are used. Under current IRS rules, home equity loan interest generally does not qualify for the home mortgage interest deduction when the proceeds are not used to buy, build, or substantially improve the home securing the loan.
However, IRS rules also address interest associated with loan proceeds used for business or investment activities. Depending on how the funds are traced and used, some interest may potentially be treated as a business or investment expense under separate tax rules and limitations.
Do not assume that interest is deductible simply because the loan is secured by your home or because the proceeds purchase real estate. Keep detailed records showing how funds were used and consult a qualified tax professional about your specific situation.
Home Equity Loan vs. HELOC for an Investment Property
A home equity loan provides a lump sum and usually has a fixed interest rate. That structure may be useful when you know approximately how much money you need for a purchase or project.
A HELOC provides revolving access to available equity during its draw period and usually carries a variable interest rate. It may provide more flexibility when expenses will occur over time, but payments and borrowing costs can change as interest rates change.
Compare the rate structure, fees, repayment terms, available credit, and risks of each option before choosing how to access your equity.
Is Using Home Equity for an Investment Property Right for You?
Using home equity to purchase an investment property can provide access to capital, but it should not be based on the assumption that property values will rise or that rental income will always cover your expenses.
Start by determining how much equity is actually available. Then evaluate the home equity loan payment, investment property financing, expected rent, operating expenses, reserves, and potential vacancies as one complete financial picture.
Loan Wolf Lending can help Florida homeowners explore home equity financing and investment property mortgage options. Call 754-755-3075 to discuss your financing strategy.