An investment property can be even more profitable if financed properly. Mortgages on rental homes are considered riskier and, as a result, are often more expensive, both in terms of the rates and fees you'll pay. You can circumvent some of these costs, however, by using a home equity loan on your primary residence. This, of course, is assuming you’re willing to accept the risk on your personal residence.
A home equity loan can be used to fund the purchase of a home that you plan on renting or using in some professional capacity.
Benefits of Home Equity Loans
Home equity loans carry several tangible benefits. Mainly, these loans have low closing costs — or even no closing costs — potentially saving you several thousand dollars. They typically have a quick turnaround time and offer the option of either a fixed-rate loan or a line of credit. A line of credit is especially useful because you only use what you need. If you only use a portion of the line to purchase the investment property, you still have availability if you need to do renovations. Additionally, interest on a home equity loan is tax deductible, whereas the interest on an investment property mortgage is not.
Risks of Home Equity Loans
While the benefits are apparent, there are also risks involved. The success of an investment hinges upon your ability to rent the property. If you have little or no experience in real estate investment, you are essentially risking your family’s home on an uncertain venture. Additionally, home equity loans typically carry higher rates than mortgages, although investment mortgage rates do run higher than loans on a primary residence. Still, you will likely pay a higher rate than you would by getting a mortgage on the new property.
To use a home equity loan to purchase an investment property, you have to have enough equity in your home. The maximum loan-to-value (LTV) on a home equity loan varies by lender but typically tops off between 80 and 85 percent. If you need $150,000 to buy your investment property and your lender has a maximum LTV of 80 percent, your house needs to have a minimum value of $187,500, assuming your home is paid off.
If you have a mortgage of $150,000 and require a $150,000 home equity to purchase the investment property, you have $300,000 in liens. This means your house must be worth at least $375,000 to meet the 80 percent LTV guideline.
In addition to having the equity, you must also have enough income to support the payments along with all of your other debt. Again, the debt-to-income ratio guidelines vary by lender but typically run between 40 and 45 percent for a home equity loan. This means the grand total of your mortgage, credit cards, auto, student loan and installment payments plus your new home equity payment can’t exceed 40 to 45 percent of your gross monthly income.