Unlocking the Potential of Home Equity Loans for Rental and Investment Properties

Home equity loans are a popular borrowing option for homeowners looking to convert some of the equity of their primary residence into cash. But can landlords and real estate investors use a home equity loan on a property they don’t live in? The answer is yes, but the process is more complex, and you’ll likely face stricter lending criteria. Here’s what you need to know about obtaining home equity loans for these properties.

How Do Home Equity Loans Work?

Before examining how home equity loans work on a second property, it’s helpful to review how they work on principal residences.

A home equity loan is a secured loan that allows you to borrow against the equity you’ve built up in your home. Equity is the amount of your home’s appraised value minus your outstanding mortgage balance. It represents the amount of your home that you actually own. Loan funds are distributed in one lump-sum payment, which you repay at a fixed rate over your loan’s term, which typically ranges from five to 30 years.

Requirements for a Home Equity Loan on Your Primary Residence

1. Sufficient Home Equity: Home equity lenders typically require you to have at least 15% to 20% equity in your home to qualify for a loan.
2. Minimum Credit Score: You’ll typically need a minimum credit score of 680, though some lenders look for higher scores.
3. Low Debt-to-Income Ratio (DTI): This ratio measures the percentage of your gross monthly income used to pay your monthly debt obligations. Many lenders set their DTI limit at 43%.
4. Stable Income and Employment: Lenders will review your employment status and income to ensure your income is steady and strong enough to support a new loan payment. Be prepared to provide your W-2s and recent pay stubs as proof of income.
5. A Strong Payment History on Your Existing Mortgage: A long history of timely payments on loans and other forms of credit shows lenders you’re a responsible borrower and likely to make good on a new home equity loan.

Home equity loans help homeowners cash out equity at lower interest rates than other forms of credit, which they can use to renovate their homes or make major repairs. These benefits also extend to second homes, where you can obtain a home equity loan for home improvements, repairs, or other purposes.

Securing a Home Equity Loan for a Rental or Investment Property

While home equity loans on investment properties aren’t as widely available as traditional ones for borrowers using their primary residence, they’re still possible to obtain. Credit unions, community banks, and specialized lenders can be good options, especially if you’re already a member or have an established relationship with them.

Eligibility Requirements for Rental or Investment Properties

1. Higher Credit Scores: Lenders typically require a 680 credit score for a traditional home equity loan. Some even work with bad credit borrowers with scores as low as 620. However, you’ll likely need a score of at least 720 to qualify for a home equity loan on an investment property.
2. Lower Loan-to-Value (LTV) Ratio Requirements: Loan-to-value ratio is the percentage of your property’s value you can borrow. You may need a lower LTV—typically around 70% to 80%—for a home equity loan on a rental or investment property. By contrast, when borrowing against your primary residence, your LTV can be as high as 85% or even 90% with many lenders.
3. Varying DTI Requirements: Lenders often look for DTI ratios similar to those required for primary residences, typically below 43%. But, some may be more—or less—cautious depending on their perceived risk of the investment property, with DTI caps ranging from 40% to 50%.

Lenders tend to view investment properties as riskier than primary residences, believing that if you run into financial difficulties, you’re more likely to walk away from the investment property than the one you live in. To compensate for this elevated risk, lenders typically charge higher interest rates. Similarly, loan terms for rental or investment properties are often shorter, usually 10 to 15 years—compared to terms of up to 30 years available for primary residence loans.

Challenges to Consider Before Applying for a Home Equity Loan

Taking out a home equity loan on a rental or investment property isn’t as common or straightforward as a standard home equity loan. These loans come with their own challenges, including stricter lending criteria and potentially higher interest rates due to their perceived higher risk.

As with all loans, approval often boils down to risk. Your approval odds improve when you’re able to alleviate your lender’s concerns. Good credit, sufficient income, and low DTI ratios can bolster your approval odds significantly. So can other factors, such as:

1. Rental Income: If you rent out your property, lenders will likely want to take a look at your income and loss records to determine how much money the rental brings in. The property could be deemed as higher risk if the cash flow is negative or the home often sits empty.
2. Property Value: Your likelihood of loan approval may be greater if your home has a high property value, since it provides more collateral for the loan.
3. Cash Reserves: Having adequate cash reserves shows your lender you’ve got a financial safety net to manage the new loan if renters stop paying rent or if the home sits vacant. Some lenders want to see a cash reserve minimum of six to 15 months of expenses to cover any gaps in rental income or surprise costs.

The Bottom Line

A home equity loan could help you fund a home improvement project on your rental or investment property, such as renovating a kitchen or bathroom. This upgrade could not only improve the home but also increase its value and potentially offer tax benefits. The IRS states you may deduct interest on a home equity loan if you use the funds to “buy, build or substantially improve the residence” that secures the loan. On the other hand, the loan carries significant risk, namely that you could lose the home to foreclosure if you default.

If you decide to get a home equity loan, having good credit could improve your likelihood of approval and securing a favorable interest rate. Before applying, it’s a smart move to check your credit report and credit scores for free with Experian. That way you can identify any issues that could harm your chances of approval and take steps to resolve them.

At O1ne Mortgage, we understand the complexities and challenges of securing a home equity loan for rental or investment properties. Our team of experienced professionals is here to guide you through the process and help you find the best loan options tailored to your needs. Whether you’re looking to renovate your property, make major repairs, or invest in new opportunities, we’re here to help.

Don’t let the complexities of home equity loans hold you back. Contact O1ne Mortgage today at 213-732-3074 for personalized assistance and expert advice on all your mortgage service needs. Let us help you unlock the potential of your investment properties and achieve your financial goals.