The real estate market is extremely competitive today, and good deals can be harder to find. When the right opportunity comes along, the last thing many investors want is to see the deal go to someone else. One way to have money sitting on the sidelines waiting to be deployed is by applying for a HELOC on a rental property.
- HELOC is also known as a Home Equity Line of Credit.
- A HELOC is a second mortgage on a rental property that works similar to the way a credit card does.
- Funds are available when and if an investor needs them with few restrictions from the lender on how the money is used.
- Real estate investors may use a HELOC for a variety of uses, including updating or rehabbing an existing rental property, or using the funds for a down payment on another rental.
- A credit line from a HELOC can be drawn on and repaid, then repeatedly used again, until the draw period comes to an end.
What is a HELOC?
Also known as a Home Equity Line of Credit, a HELOC is a second mortgage on a rental property that works similar to the way a rotating line of credit on a credit card does. The lender sets the credit line dollar amount using the rental property as security. The borrower can draw on the line of credit as needed, repay the balance over time, then use the credit line again.
In most cases a HELOC has a draw period – such as 5 or 10 years – during which the borrower can draw on the credit line and make monthly interest-only payments.
When the draw period expires, the borrower must make monthly payments of principal and interest (similar to paying a second mortgage) until the outstanding balance is repaid in full. The repayment period of a HELOC varies from lender to lender, but may last up to 20 years.
Lenders normally set few restrictions on how the funds from a HELOC can be used. Some examples of how real estate investors use a HELOC on a rental property include:
- Updating and improving an existing rental property to obtain a higher monthly rent
- Making capital repairs such as replacing the HVAC or installing new flooring
- Forcing equity appreciation and increasing property value by converting an attic or basement into additional rentable square footage
- Paying off the outstanding mortgage on another rental property
- Using funds from a HELOC as the down payment for an additional rental property
Is a HELOC on a rental the same as a primary residence?
HELOCs are available for both primary residences and rental properties and generally work the same way. However, there are some key differences with a rental property HELOC that investors should understand.
Stricter approval requirements
Lenders view investment property loans as generally having higher risk, and HELOCs on rental properties even more so, because a HELOC is a second mortgage. Real estate investors who are in desperate need of cash may find it difficult to qualify for a HELOC.
Higher fees and interest
Also, because of the view that HELOCs are riskier loans, fees and interest rates on HELOCs are higher than first-position investment property mortgages. In order to be compensated for extending a riskier loan, lenders expect more in return, in the form of larger up-front fees and higher monthly interest rates.
HELOC lenders are difficult to find
Again, because of risk, finding lenders willing to make a HELOC on a rental can be difficult. Most lenders prefer to make lower-risk loans where the odds of default are lower and the likelihood of being repaid are higher. Depending on the rental property and the real estate market, a local credit union may be a good source for finding a HELOC loan. Credit unions aim to serve the local community, and may be interested in working with an investor looking for funds to create additional rental housing.
Some private real estate lenders may also be willing to make a HELOC on a rental property. Oftentimes private lenders are fellow real estate professionals who invest in debt instead of equity. They understand how rental property works, and how an investor can use a HELOC to add value to an existing home or to scale up and grow a rental property portfolio.
How to get a HELOC on a rental property
Here are the typical requirements investors can expect when shopping around for a HELOC on a rental property:
- Strong credit score of 720 or higher, out of a perfect credit score of 850
- Loan-to-value ratio (LTV) of no more than 80%, including the first mortgage (if applicable) and the HELOC
- Enough gross rental income and net operating income (NOI) to pay the total monthly debt service and still have a healthy positive cash flow
- Seasoning of existing tenant, such as renting to the same tenant for more than one year
- Features and amenities that make the property easy to rent should the existing tenant leave, such as having a dedicated space for working from home
- Sufficient cash held in a reserve account for unexpected repairs, longer than anticipated vacancy in between tenant turns, and for several months of mortgage payments
Because a HELOC is similar to a second mortgage, an investor looking for a HELOC on a rental property can expect to pay for an appraisal, property inspections, title search and doc preparation fees, and loan closing costs.
A lender will likely want to review the property income statement, real estate balance sheet, and tenant rent roll for the current and past two years. Many lenders will also want to know about other rental properties that a borrower has, including the owner’s equity and financial performance of each.
There are few restrictions on how funds from a HELOC are used. However, most lenders will not want to see money from a HELOC being used to cover the negative cash flow from underperforming rental properties a borrower might have.
Pros and cons of a rental property HELOC
Although getting a HELOC may be challenging, for some investors a rental property HELOC may be worth the effort. Here are some of the potential pros and cons to consider:
Pros of a HELOC on a rental property
- Funds are available when and if an investor needs them, in the amount that an investor needs.
- Line of credit can be repeatedly used and repaid during the draw period.
- Flexible use of funds from a HELOC, including making updates to increase property value and rental income, or raising the down payment for another rental property.
- Interest paid on a HELOC is a deductible expense, and may be lower than the interest rate on a credit card or hard money loan.
- Closing costs of a HELOC may increase the property basis, creating a larger depreciation expense deduction.
Cons of a HELOC on a rental property
- Interest rates and loan fees on a HELOC are higher than a first-position investment property loan.
- HELOC loan fees and closing costs deducted from the credit line will leave less cash available to use.
- A HELOC with a variable interest rate can become expensive, requiring more cash flow than anticipated to repay the loan.
- Owner equity in the rental property built up over time is decreased when a HELOC is taken out.
- Risk of losing the rental property to foreclosure if things don’t go according to plan.
Options to consider besides a HELOC
Taking out a HELOC on a rental property may not be the right way for every investor to raise money. Here are some alternatives that other investors use:
Investors with a high credit limit often use a credit card as a way to obtain funds. Many credit card companies offer low or 0% interest rates for new card members for a certain period of time.
Many personal loans are unsecured, which means that existing assets such as the rental property or primary residence are not used as collateral. However, loan fees and interest rates may be higher than a HELOC or credit card.
Investors with a significant amount of equity in a rental property may find that doing a cash-out refinance is a good way to raise capital. Unlike a HELOC where funds are available when and if they are needed, a cash-out refi provides an investor with all of the funds up front in one lump sum.
HELOC on a primary residence
Getting a HELOC on a primary residence is generally easier than a HELOC on a rental property. Lenders usually place very few restrictions on how the line of credit is used. So, funds from a primary residence HELOC can be used for any purpose a real estate investor chooses.