*Loan-to-Value Ratio
How a HELOC Works
A HELOC is a line of credit based on the equity you’ve built in your investment property. Equity is the difference between the value of the property and the balance on the mortgage — if you own it outright, you have 100% equity.
That doesn’t mean a bank, credit union or online lender will let you borrow 100% of your equity. In general, lenders allow you to borrow up to 80% of the value of your property minus any outstanding mortgage balances. Once the HELOC money is borrowed, spending that money might be as simple as swiping a bank card when you buy something, slowly drawing down the approved credit limit. Repay the HELOC in full, plus interest, and that original amount is available again. These two phases are known as the draw period and the repayment period:
- Draw period: Once you accept a HELOC from a lender, your draw period begins. The lender sets the time for the draw period, but it’s usually between five and 10 years. During this time, you can withdraw money as needed, up to the amount of your line of credit, while typically making interest-only payments.
- Repayment period: Once the draw phase ends, you enter the repayment period of the HELOC, typically between five and 20 years. During this time, you make principal and interest payments to repay the amount of credit you used. Because many HELOCs carry variable interest rates, your monthly payment amount might fluctuate.
>> Related: What is a HELOC?
HELOCs on Investment Properties vs. Primary Residences
While most lenders offer HELOCs or second mortgages on primary residences, fewer lenders provide HELOCs on an investment property. Additionally, the eligibility requirements for an investment property HELOC are often stricter, and the interest rates are usually higher than for HELOCs on a primary residence.
So why pursue a HELOC on an investment property if it’s potentially difficult and more expensive than one on your primary residence? You might prefer the lower risk of putting up your investment property as collateral than the one where you live primarily.
Pros and Cons of Getting a HELOC on an Investment Property
The point of an investment property is generally to earn a return. Hopefully, you’re seeing that through a healthy rental income, but maybe you want or need additional money. You could convert the equity you’ve built through years of mortgage payments, improvements, natural appreciation or all of the above into cash. A HELOC is one way to get that cash, but it’s not the only way. Here are some of the advantages and downsides to getting one.
Pros of Getting a HELOC on an Investment Property
Unlike a home equity loan’s lump sum that you must begin repaying immediately, a HELOC only charges interest on what you use. Minimum draw amounts or fees notwithstanding, you could keep the line of credit open for emergencies. You won’t make payments if you never use it.
- Flexibility — withdraw money as needed during the draw period with interest-only payments.
- Lower rates than a credit card or personal loan
- Less risky for you than tapping the home equity of your primary residence, since you won’t risk losing the home you live in to foreclosure
Cons of Getting a HELOC on an Investment Property
You may not get the full benefits of a HELOC when you take one out on an investment property — rates are generally higher, and choices are fewer than those on primary residences.
- Many lenders don’t offer them, and requirements may be strict for those that do.
- Higher interest rates on a HELOC for an investment property than a primary residence
- Risk of foreclosure on your investment property
- Possible closing costs and fees
Should You Get a HELOC on an Investment Property?
A HELOC on an investment property may help you generate more rental income or a higher sales price for that asset if you use it to fix up the property. Or, you might be ready to tap the equity you’ve built to accomplish a different goal.
The decision to get a HELOC on an investment property depends on your financial objectives: improve the return on your investment property or cash out at least some of your equity to use for something you want or need.
Calculate Your Potential Return on Investment (ROI)
If you use HELOC funds to improve your investment property, choose your renovation projects carefully to make sure you’ll recoup your costs. You’ll need to know:
- Project cost: Just as you shop around for the best HELOC, obtain multiple quotes for the kitchen remodel, a new roof or other project you want done.
- Project impact: This is the trickier one. You’ll want an idea of how much you could increase the rent or sales price based on the new kitchen, roof or other improvement you make.
Here’s a practical example: Let's say you want to calculate the ROI of a $20,000 kitchen remodel. You’ve locked in the cost with your contractor after comparing multiple bids and references and researching rents on comparable properties in your area. Based on that information, you believe that you can increase your monthly rental income by $200.
$2,400 additional annual rent x 9 years = $21,600
You’ll recover the cost of the improvement in a little more than eight years and show an ROI of 8% by year nine.
ROI to Sell
You may also want to calculate the ROI to sell the property. If your $20,000 kitchen remodel increases the sale price by $50,000 when you sell a year later, your ROI is 50%. A real estate agent or other professional can help you determine the value of a home improvement project, whether it’s a kitchen or bath remodel, window or door replacement or new porch or flooring, to name a few.
Home Equity Loan Calculator
Most lenders require a loan-to-value (LTV) ratio of 85% or less to qualify for a home equity loan. Use our calculator to see if you may be eligible to draw on your home equity and how much you might be able to borrow.
LOAN INFORMATION
This is the ratio between how much you still owe on your home and how much it is worth. Generally, you need an LTV of 85% or less to tap into your home equity.
Current loan-to-value (LTV) ratio
50.0%
This is how much we estimate you can borrow. Lender requirements will vary.
YOU MAY BE ABLE TO BORROW UP TO
$140,000
Your outstanding mortgage balance exceeds 85% of your home value.
Since most lenders limit the loan-to-value (LTV) ratio for home equity loans at 85%, you may not be eligible for a home equity loan at this time.
Lenders typically require a credit score (FICO) of 620 or higher to qualify for a home equity loan or HELOC.
Lenders typically require a credit score (FICO) of 620 or higher to qualify for a home equity loan or HELOC.
You’ll likely need to improve your credit score before you can tap into your home equity. Check out some tips to do so here.
How To Get a HELOC on an Investment Property
Obtaining a HELOC on an investment property — or any HELOC — starts with establishing your eligibility and ends with selecting the offer with the best terms and rates for you.
Establish Your Eligibility
Lenders will evaluate you and your property when determining your eligibility for a HELOC on an investment property. They want to know:
- Property value: Before a lender can decide how much you may borrow, it needs two pieces of information: your property’s current market value and the balance on your mortgage. The lender will appraise the investment property to determine the market value. You can always use an online HELOC calculator to get a feel for your potential borrowing amount.
- Debt-to-income ratio: Your DTI ratio is your monthly debt payments — mortgage, car payment, credit card bills — divided by your gross monthly income. Most lenders are looking for a DTI below 50%.
- Credit score: You will need at least fair credit to qualify for a HELOC, but some lenders may require good to excellent credit. No matter what your lender requires, those with higher credit scores are more likely to receive a lower interest rate at favorable terms.
- Credit history: Lenders may also ask you to show a steady history of income (e.g., rental payments) for the property and/or require you to have liquid cash reserves to cover at least six months of expenses.
Select the Best Offer
As with any financing, apply to more than one HELOC lender to weigh all of your options. This lets you compare offers and select the most favorable rates and terms. A typical application process may involve these steps:
Step 1: Research Lenders
Look for lenders that offer investment property HELOCs. Don’t forget to start with your own bank or credit union — some lenders, like Bank of America for example, offer perks to existing members.
Step 2: Gather Paperwork
Applications will move more quickly if you have already gathered the paperwork many lenders request, like bank statements, mortgage statements and proof of rental income.
Step 3: Get Prequalified
Some lenders may allow you to complete or at least start the application process online. Look for lenders that offer pre-qualification: applications that give you an idea of rates and terms without a hard credit pull.
Step 4: Discuss the Appraisal
While some lenders have proprietary models for determining your property’s market value, you may need to work with the lender to schedule an in-person appraisal.
Step 5: Review the Offer
Once your lender reviews your application and ensures that your credit score, DTI, cash reserves, rental history and property appraisal meet their requirements, it’s time to review the terms and details of your HELOC offers. Having several gives you a better chance of landing the lowest rate at the best terms.
Alternative Financing Options
A HELOC isn’t the only way to finance investment property improvements. It’s always a good idea to compare your HELOC offers to other types of financing, including the options below.
With this type of financing, you don’t need to put up property as collateral, so you don’t need to meet any equity requirements. The eligibility criteria primarily relate to your credit score, and you get the full value of the loan in a lump sum. However, the interest rates for a personal loan are usually higher than for a HELOC.
>> Related: Best Personal Loans
Like a HELOC, a credit card gives you on-demand access to funds, so you only need to take out as much money as you need. However, the spending limit for a credit card may be lower than the limit on a HELOC, and the interest rate will probably be substantially higher with the exception of a 0% APR card or balance transfer.
With this option, you would refinance the loan on your rental property for a higher amount than you currently owe and get the difference in cash. The idea is to get a similar or lower interest rate than your current one. Otherwise, your monthly payments may rise dramatically.
With a home equity loan, you get the entire balance upfront, which can be useful if you need a lump sum right away. Not all of the best home equity loan lenders offer home equity loans on investment properties, and if you do find one, you’ll probably pay a higher interest rate than the home equity loan rate for your primary residence.
>> Related: What is a Home Equity Loan?
It’s generally easier to find a lender for a HELOC on your primary home. The eligibility requirements and interest rate may be lower than a HELOC on an investment property. However, this option requires you to put your home up as collateral, which means you could be subject to foreclosure on your residence if you default on the payments.
The Bottom Line
An investment property can be more than reliable rental income — you could leverage it to access funds for emergency repairs or property improvements. That may be money well spent to increase the return on the asset you worked hard to purchase and maintain.
A HELOC allows you to use your equity in the property to qualify for a line of credit that may be worth up to 80% of its value. You have a draw period of several years, during which you can withdraw money as needed. You only need to pay back the money you use, and you may be able to make interest-only payments until your repayment period begins.
However, there are some potential disadvantages to an investment property HELOC. Not all lenders offer this type of financing, and eligibility requirements are often strict. Additionally, you could lose your investment property if you can’t repay the loan.
Frequently Asked Questions About HELOCs on an Investment Property
The amount of money you can borrow with a HELOC depends on how much equity you have and your credit score. Lenders are looking for an average or better credit score and at least 20% equity, possibly more for investment properties. You can use an online calculator to gauge your borrowing limits.
You may be able to deduct the interest you pay on HELOC funds you use for substantial improvements to your investment property. However, there are limits based on your tax filing status. It’s best to consult a financial or tax professional to know for sure.
In general, a HELOC doesn’t factor into the capital gains calculation. Taking out or paying off a HELOC probably won’t affect your capital gains tax liability when you sell your home.
Taking out a HELOC on an investment property can be financially risky, especially if you rely on rental income to cover the repayment costs. If you are unable to pay back the HELOC, you may lose your rental property. Additionally, many lenders don’t offer HELOCs on investment properties, so it may be difficult to find this type of financing.
Editor’s Note: Before making significant financial decisions, consider reviewing your options with someone you trust, such as a financial adviser, credit counselor or financial professional, since every person’s situation and needs are different.
If you have feedback or questions about this article, please email the MarketWatch Guides team at editors@marketwatchguides.