Many homeowners look to home equity lines of credit (HELOCs) to fund home improvements, pay off high-interest debts and cover emergency expenses. But this type of loan, which allows a property owner to borrow against the equity in the home, can be difficult to get – especially when the property in question is an investment property.
In this post, we’ll explain whether or not you can get a home equity line of credit on an investment property, and the pros and cons.
What are investment property loans?
Investment property loans are mortgages used to buy, build or improve second homes and investment properties – essentially any property other than the borrower’s primary residence. They may come in the form of a primary mortgage used to buy or refinance the property, a HELOC or a home equity loan.
Of those, the HELOC is unique in that it acts more like a credit card that is collateralized by your home. Like a credit card, the lender approves you to borrow up to a certain amount, then you borrow against the available credit when needed. As you repay the amount borrowed, your available credit is replenished. And you only pay interest on the money that you actually use.
Lenders are typically far more strict in their underwriting of investment property loans than they are for a borrower’s primary residence, and usually require more money down. Why?
Adam Smith, president and CEO of Colorado Real Estate Finance Group in Greenwood Village, Colo., said it’s because investment properties are already considered high risk. “You have to have somewhere to live, so the assumed risk factor is lower on a primary residence than it is on an investment property,” Smith said. In other words, you’re probably more likely to cover expenses for a primary home if you find yourself in a financial pickle, versus prioritizing a secondary property.
And with a HELOC, there’s an extra risk factor involved as well. Unless you own the property free and clear (meaning you paid cash or paid off the mortgage), a HELOC is a “junior-lien.” In other words, it’s secondary to your first mortgage.
If you stop making mortgage payments and the property goes into foreclosure, when the property is sold to pay off your debts, your primary mortgage will be paid off first. If there is not enough equity to pay off both the first mortgage and the HELOC, the HELOC lender may not get the full amount owed.
“So you’ve got a higher risk due to the occupancy and a higher risk due to the loan position,” Smith said. “It’s the perfect storm of high-risk lending.”
Getting a HELOC on an investment property
Despite these challenges, it is possible to get a HELOC on an investment property. Just keep in mind that the bar for approval may be set higher than it would be if you were applying for a mortgage to purchase an investment property or a HELOC on your primary residence. Let’s take a look at some of the potential hurdles you might be facing.
What is your credit score?
While there are many mortgage programs available to help borrowers with credit troubles, borrowers seeking a HELOC on an investment property will likely need good credit to get approved.
Minimum credit scores will vary by lender and are taken into account along with other factors, but a report from Equifax revealed that in 2017, more than 80% of HELOC borrowers had credit scores of 700 or above.
If you need to boost your credit score before applying for a HELOC, here are a few places to start:
- Get a copy of your credit report. You can get a free copy of your credit report every 12 months from each of the three credit reporting agencies. Order yours at AnnualCreditReport.com and check it for errors, such as incorrectly reported late payments or credit balances. If you find any errors on your report, follow the credit bureau’s instructions for disputing them.
- Check your credit score. A credit report won’t tell you your all-important credit score. To get a free one, check out our list here.
- Pay your bills on time. On-time payments are one of the most significant factors the credit bureaus consider when calculating your credit score. If you have trouble remembering to pay your bills on time, set up reminders or enroll in automatic payments. A late payment remains on your credit report for seven years, but the more time has passed since the late payment occurred, the less of an impact it has on your score.
- Reduce the amount you owe. Work on paying down your balances on credit cards, auto loans, student loans, etc. Paying off your outstanding debts, especially revolving credit card debt, can have a significant impact on your credit score.
What is your debt-to-income ratio?
Another factor lenders consider in approving a HELOC on an investment property is the owners debt-to-income (DTI) ratio. DTI measures your ability to manage your debt payments by comparing your monthly debt payments to your overall income. To calculate your DTI, divide your monthly recurring debt payments by your gross monthly income.
For example, if you have total monthly debt payments of $2,500 (including your current mortgage, auto loan, credit cards, student loans, etc.) and your income is $5,000 per month, then your DTI would be 50%.
When you apply for a HELOC, the lower your DTI, the better your chances of getting approved. As with credit score requirements, each lender has their own maximum DTI requirements, but if your DTI is higher than 43%, you may have a hard time finding a lender willing to approve your HELOC.
How much equity do you have in the property?
To qualify for a HELOC, you need to have available equity in the property, meaning the amount you owe on the first mortgage is less than the value of the property. Banks typically set a maximum loan-to-value (LTV) limit for how much you can borrow. That may be somewhere around 80% to 90% of the value of the property, minus the amount you owe.
For example, say your property is worth $400,000, and you currently have a mortgage balance of $300,000. Your current LTV would be 75% ($300,000 ÷ $400,000). If your lender has a maximum LTV of 80%, you may only be able to borrow $20,000 from a HELOC. That’s five percent of $400,000, which would bring your total LTV up to 80%.
Smith says a lender considering a HELOC would require more equity on an investment property than they would on a primary residence.
“Ideally, your HELOC would be in first position – you would own the property free and clear. But if you do have an existing mortgage, you would owe only about half of what the property is worth,” he said.
Borrowers who do not have enough equity in the property to qualify for a HELOC don’t have a lot of good options for building it quickly. Equity increases when a) you pay down the mortgage, or b) the value of the property increases. If you’re interested in a HELOC, you probably don’t have a lot of extra cash laying around that can be used to pay down your existing mortgage balance. You may be able to make some improvements to the home that will increase its value, but that also requires investing funds into the property. And finally, you don’t have any control over the real estate market and how your home’s value fluctuates based on supply and demand in your area. So without enough equity to qualify for a HELOC, you may have to consider other alternatives.
Alternatives to getting a HELOC on an investment property
Whether you are an ideal HELOC borrower or not, it’s a good idea to look into alternatives to a HELOC on your investment property. Here are a few you might consider:
A cash-out refinance is the refinancing of your existing mortgage loan. Your new mortgage will be for a larger amount than your current mortgage, and you receive the difference between the two loans in cash.
Getting approved for a cash-out refi also requires having adequate equity in the property. However, the advantage of a cash-out refi, as opposed to a HELOC, is that cash-out refis are generally fixed-rate loans. HELOCs are typically adjustable-rate loans, so if interest rates go up, your monthly payments could go up as well.
Personal loans and lines of credit are similar to a HELOC, but they are unsecured loans, meaning you don’t have to pledge the property as collateral. So if you run into financial trouble and can’t afford to make loan payments, you aren’t at risk of losing the property.
There are two potential downsides of choosing a personal loan over a HELOC. First, since personal loans aren’t collateralized, they typically come with higher interest rates. Second, personal loans usually have shorter loan terms. A personal loan is usually repaid over two to seven years, whereas a HELOC will generally allow you to withdraw funds for up to 10 years and give you up to 20 years to repay.
If your cash needs are modest and you don’t qualify for a HELOC on your investment property, you might consider using a credit card. However, the interest rate on a credit card will likely be much higher than you’d receive with a HELOC, unless you can find card with a decent intro APR.
If you believe a HELOC is the right choice for you, Smith recommended starting your search with a retail bank. “The wholesale mortgage world is still a little skittish,” he said. “Your best bet is banks that primarily do depository business. They’ll offer HELOCs to keep their checking account holders happy.”
There are a lot of potential barriers to taking out a home equity line of credit on an investment property, but a HELOC can be a smart financing tool for a property owner in need of funds to fix up the property or invest in another one.