Can you use a home equity loan to buy a rental or investment property?
Investing in real estate is one way to build generational wealth for the future while bringing in passive income for today. Yet if you’re looking to build up your investments through a rental or investment property, you’ll need to come up with a good chunk of capital to get started.
Just like buying a primary home, financing an investment property through a mortgage comes with a down payment and closing costs. And you may need to borrow money if you don't have much savings.
For homeowners looking to leap into real estate investing, you might be able to tap into your home equity to finance your purchase. Strong growth in home values has resulted in more than $200,000 in tappable equity for the average homeowner, according to the ICE Mortgage Monitor.
Getting into the real estate investment game comes with risk, however. Here’s what to know before using your home’s equity for buying an investment or rental property.
Should you use your home equity to invest in real estate?
While you can use a home equity loan to buy a rental or investment property, that doesn’t mean you should. Borrowing from your home equity is risky, especially if you don't know if an investment is a sure thing.
Among the two most popular ways to tap into your home’s equity are home equity loans and home equity lines of credit — commonly called HELOCs. Both types of loans are ways to borrow from the money you’ve already paid into your home, based on your home’s appraised value. Many folks use home equity loans and lines of credit for home-related projects, like repairs, improvements or renovations that can increase your property’s value. They’re also used to consolidate high-interest debt, pay for education costs or cover unexpected bills.
But there are no restrictions as to how you can use the money you borrow with a home equity loan. As long as you have the equity, income and credit history needed for approval, you can use your funds to invest in real estate or buy a rental property.
Keep in mind that taking out a home equity loan is like a second mortgage. If you don’t repay what you borrow, you could end up losing your home.
????How to calculate your home equity
Every mortgage payment gets you one step closer to owning your home outright. The part that the bank owns is what you pay in your mortgage every month. Home equity is how much of your home you own compared to what you owe — or what’s left — on your mortgage.
You can calculate your home equity by taking your home’s current value and subtracting what you owe on your mortgage. The final number is your home equity.
[home’s value] ➖ [mortgage balance] ???? [home equity]
Risks to using home equity to invest in a rental property
Using a home equity loan can unlock access to the cash you’ve already paid into your home. These lending products tend to have more favorable terms compared to unsecured personal loans, like lower interest rates and longer repayment periods.
But because home equity loans and HELOCs use your property as collateral to secure the loan, they also come with a huge risk: Missing or falling behind on your loan’s payments could result in you losing your home.
Another big risk comes down to the unpredictability of the real estate market. While median home prices have increased more than 45% over the past four years, according to the Case-Shiller National Home Price Index, it’s not easy to predict what will happen with your home’s value. If it were to decrease significantly or depreciate, you could end up owing more on your loan than your primary residence is worth — a situation referred to as being “underwater” on your loan. If this were to happen, you could end up needing to sell your home to pay back your home equity loan on time, however unlikely it might sound.
Risks of investing in real estate
Real estate leads as the best long-term investment, according to most Americans in a recent Gallup poll, with 36% of those surveyed choosing real estate over stocks, mutual funds, gold and other options. But real estate investing has its risks as well.
While the market is red hot right now, it’s important to remember that the market won’t always go up or stay up. The market crash of 2007–2008 and protracted Great Recession that followed was difficult for homeowners and investors alike, resulting in some 3.8 million foreclosures between 2007 and 2010 estimated by the Fed.
Deciding which properties to invest in takes research. You’ll want to understand the general demand, market value, vacancy rates and estimated taxes of the areas you’re interested in, not to mention the available homes or buildings themselves. And you’ll need to factor in long-term maintenance, such as needed repairs as the structure ages and time to manage future tenants, if you plan to rent it out for passive income.
Other long-term maintenance includes staying up to date on local laws and ordinances related to zoning, compliance and other laws as a homeowner or property owner. You’ll have to pay attention to permits, laws that could get passed, tax rates and more.
Unless the property can at least pay for itself, you run the risk of losing two properties if your investment doesn’t pan out. The debt and uncertainty might be too much for some folks investing in real estate without careful consideration, a strong budget and a stomach for unreliability.
Dig deeper: 4 ways to get equity out of your home while rates are high
Benefits of using home equity to invest in a rental property
If you’re comfortable with the risks associated with real estate, using your home equity could be a way to invest in a property or rental income over other types of financing.
You can get quick access to cash
A home equity loan gets you quick access to the cash you’ve already paid into your home. You won’t need to take out a new mortgage on the property — which could come with a lengthy application, approval and closing process.
Your interest rate could be lower
A home equity loan is a secured loan that uses your home as collateral. Secured loans typically offer lower interest rates than unsecured loans, like personal loans. The less interest you owe on a loan, the lower your monthly payment — or the more money you can put toward your loan’s principal to pay down what you borrow faster.
You can increase your down payment
Because home equity loans pay out what you borrow in one lump sum, it could mean that you have more money up front to increase your down payment on an investment property. Generally, the higher your down payment, the lower your monthly payment. And if you can put down at least 20% of your property’s purchase as cash, you won’t be responsible for private mortgage insurance — or PMI — which can save you up to $70 a month for every $100,000 borrowed, according to Freddie Mac.
Investment properties tend to have stricter financing requirements. Increasing your down payment or how much cash you have on hand could make it easier to afford the investment property in the long run.
Loan options for using your home equity to buy an investment property
There are a few ways to borrow from your home equity. How you borrow your home equity could determine how you receive, repay and spend that money on an investment or rental property.
Home equity loan
A home equity loan is the most popular way to use your home’s value to invest in real estate. This type of loan provides the amount you borrow up front in one lump sum. You then make monthly payments until your loan is paid back in full. Home equity loans usually come with fixed interest rates and terms upward of 30 years, much like a traditional mortgage.
A home equity loan is best if you know how much you need to borrow and prefer to keep the same monthly payment for the life of your loan.
Home equity line of credit (HELOC)
A HELOC is a revolving line of credit, similar to the way a credit card works. You’ll take money out as needed during what’s called the draw period, which usually lasts about 10 years. After the draw period comes your repayment period, which can last about 15 to 20 years. Your payments are amortized to make sure you can pay off what you’ve borrowed plus interest on time.
Unlike a home equity loan, HELOCs come with variable interest rates. Depending on your lender, you may be able to make interest-only payments during the draw period, though you can often pay toward your principal too.
A HELOC might be a good idea if you need to figure out how much you need to borrow and want to borrow from your line of credit as needed — say, to pay for repairs or maintenance on your investment property.
Cash-out refinance
With a cash-out refinance, you’re replacing your current mortgage with a new home loan whose amount is more than you owe. You can then use your new loan to pay off the remaining balance of your old mortgage, “cashing out” the remainder of what’s left.
Whereas a traditional refinance replaces one mortgage for another with more favorable repayment terms for the borrower — like lower monthly payments, a lower interest rate or both — a cash-out refinance creates a larger mortgage payment. It might be worth it if you can afford the new payment on your current home while using the cash to buy an investment property.
Dig deeper: Home equity loan vs. HELOC: Which is best for borrowing against your equity?
How to get a home equity loan for an investment property
If you’re ready to get a home equity loan to buy an investment property, confirm you can meet minimum requirements, and ready your documentation for providing to your lender.
Check your credit score. Credit requirements tend to be stricter for investment properties compared to primary homes. The exact credit score you need varies by lender, but the higher your credit score, the more likely you are to qualify for the full amount you want to borrow.
Gather personal and financial documents. Get your tax returns, bank statements, government-issued IDs and other documents ready for your application. Your lender may ask for pay stubs, W2s and other financial statements for income verification and to prove you’re responsible enough to repay what you borrow.
Make sure you have enough equity. Lenders have restrictions on how much you can borrow. Your combined loan-to-value ratio (CLTV) — your primary home and your home equity loan — can’t be more than 80% of your home’s value, although the CLVT varies based on the lender you go with. You should have at least 20% equity in your home before you take out a loan or line of credit.
Get preapproved. Like a traditional mortgage, preapproval for a home equity loan lets you know how much you might actually qualify for. Scoring models allow at least a 14-day window in which you can shop for rates from different lenders and have it count as a single query on your credit, while FICO specifically allows for up to 45 days.
Compare and apply. Compare lenders to see which offers the best rates, fewest fees, longest repayment terms and fastest approval. Because each lender has different requirements, see which ones you’re eligible with before completing an application.
When completing an application, your lender will let you know if you need to send along any extra documents or paperwork. Underwriting could take a few weeks or up to a month before your application is approved.
Alternatives for financing an investment property
While using your home equity is one way to buy an investment property, you have other ways to fund your real estate ventures, including conventional loans and all-cash purchases.
Conventional bank loan. Many mortgage lenders offer conventional loans for second homes, vacation properties and investments. Criteria to qualify may be more strict than for a primary property but can vary widely by lender, area and property use.
Peer-to-peer (P2P) loan. There are a few peer-to-peer lending platforms that match up investors with borrowers to help them finance real estate purchases, including PeerStreet and Fundrise. However, you might pay higher fees and interest rates than other loan options for the convenience.
Personal loan. Most personal loans are unsecured, meaning you won't lose your home if you fall behind on payments. But they tend to come with higher interest rates and shorter repayment terms than home equity lending options. You may not be able to borrow the entire amount you need to fund your investment with a personal loan compared to a home equity loan or traditional mortgage.
Cash. Using your savings is among the easiest ways to avoid borrowing. It's likely to take longer to achieve your goal, depending on the area you're interested in investing in, but it means you won't need to pay interest, take out loans — and give up your home if you find yourself underwater.
Dig deeper: Personal loan vs. home equity loan: Which is the best fit for your financing?
Sources
ICE Mortgage Monitor: Historically Strong Home Price Growth Pushes U.S. Mortgage Holders’ Tappable Equity to Record $11T, ICE. Accessed August 6, 2024.
Stocks Up, Gold Down in Americans' Best Investment Ratings, Gallup. Accessed August 6, 2024.
Have Borrowers Recovered from Foreclosures during the Great Recession? Federal Reserve Bank of Chicago. Accessed August 6, 2024.
About the writer
Dori Zinn is a personal finance journalist with more than a decade of experience covering credit, debt, investing, real estate, student loans, college affordability and personal loans. Her work has been featured in the New York Times, the Wall Street Journal, Yahoo, Forbes and CBS News, among other top publications. She loves helping people learn about money.
Editorial disclaimer: Information on this page is for educational purposes and not investment advice or a recommendation to buy any specific asset or adopt any particular investment strategy. Independently research products and strategies before making any investment decision.
Article edited by Kelly Suzan Waggoner