How to Get a Home Equity Line of Credit on a Rental Property
You’re looking to cover a big-ticket repair on your rental property — like a new roof or new windows — and you’re thinking of applying for a home equity line of credit (HELOC) to fund the project.
But just because you can secure a home equity credit line doesn’t necessarily mean it’s the best decision. With that in mind, let’s take a look at how HELOCs work to help you determine whether it’s something you should pursue.
HELOC: An Overview
A HELOC is a line of credit that you secure against your property. When you take out a HELOC from a lender, you gain a revolving credit line with a fixed amount, and you can use the funds in any way you need. To qualify, you just need to have enough equity in your house for the loan amount you’re applying for.
Most people use home equity credit lines for home improvement projects. For example, you can use it to build a new deck, fix structural issues, or renovate your kitchen. You can also use a HELOC to consolidate loans with higher interest rates — like credit card debt. You can also use a home equity line to buy another property.
A HELOC comes with a fixed time period — or draw period — which the lender determines. For example, you may secure a HELOC with a 10-year plan, paying interest over that period.
During the draw period, you are able to tap into your credit line as many times as you want. Let’s say you have a $100,000 home equity line and take $50,000 out. You’ll have to make interest payments on the funds you’ve withdrawn. When you pay back that $50,000, you’ll have access to your full $100,000 credit line again.
After the draw period is over, you enter the repayment period of the loan. You’ll need to consider refinancing your HELOC if you want to draw from these funds again.
HELOC vs. Home Equity Loan
HELOCs are often confused with home equity loans. While the two are similar in that they both provide funding for home repairs, there are some differences to note.
- Variable interest rates and monthly payments
- Low APR
- Funds are available as needed
Home Equity Loan
- Fixed-rate of interest and monthly payments
- High APR
- Funds are distributed in one payment
- Repayment is required after the loan is issued
How to Get a HELOC for a Rental Property
In general, it’s much easier to secure a HELOC on your primary home property. In recent years, mortgage lenders have increased their qualifying criteria, making it harder to obtain one for a rental property. So, if you’re looking to improve cash flow to cover a second mortgage on an investment property, you might have to look for a different financial instrument.
If you apply for a HELOC, be prepared to go through a somewhat rigorous approval process before you can access funding.
- Check Your Credit Report
- Look into Your Loan-to-Value Ratio
- Gather Rental Property Data
- Check Your Debt-to-Income Ratio
- Build a Cash Reserve
With that in mind, here are some preliminary tasks to complete before applying for a HELOC.
1. Check Your Credit Report
A lender is going to want to see a strong credit report when reviewing your HELOC application — even more so than for a mortgage.
In most cases, you’ll need a minimum score of 720 to get a HELOC. So, if your credit is hovering around 700, try and free some debt and give your credit score a boost. Otherwise, you probably won’t be eligible.
2. Look into Your Loan-to-Value (LTV) Ratio
The lender is also going to look for your loan-to-value ratio (LTV), which indicates the difference between what you owe on your mortgage and the home’s market value. In general, putting a larger down payment on a house leads to a lower LTV.
The higher your LTV, the riskier the loan looks to a lender. As such, the lender is most likely going to want to see a maximum loan-to-ratio value of 80%.
Suffice it to say that if you’re heading toward foreclosure on your first mortgage, you will need to come up with a different plan for financing.
3. Gather Rental Property Data
Additional qualifications may include your rental history and your overall cash reserves.
You should also be prepared to provide financial information on any other rental properties that you own, too, as well as whether you have property loans on them.
4. Check Your Debt-to-Income (DTI) Ratio
A debt-to-income ratio (DTI) is the percentage of your monthly gross income that goes toward debt. This is one of the most important factors that lenders look for when issuing a loan, as they want to make sure you won’t default on it.
Calculating DTI is easy. All you have to do is add your monthly debt payments, then divide that figure by gross monthly income. You can also head over to Wells Fargo and check out their free DTI calculator if you don’t want to do this manually.
There are two types of DTI to consider.
Front-end DTI includes housing expenses — like mortgage principal, taxes, interest, insurance, additional equity line payments, and HOA fees.
Back-end DTI includes installment and revolving debts. For example, this may include credit card debt or car loans.
Check with your bank before applying for a HELOC to see what their standard DTI range is for a home equity line of credit. That way, you can lower your DTI if you need to before you apply.
5. Build a Cash Reserve
If you’re approved for a HELOC, the bank will let you borrow as much as 90 percent of the equity you have in your home. So, if you own 30% of your house, you may be able to tap into up to 27% of the value of the home.
The last thing you want to do is take out a credit line against your house and be unable to repay. By building up a solid cash reserve, it’ll be easier to secure your credit line in the first place, and easier to repay what you’ve drawn.
Tips When Applying for a Rental HELOC
Watch out for Fees
You can expect to pay closing costs on your HELOC, which are generated during the originating, underwriting, and closing process of the credit line.
You should also look into any possible penalties that could be baked into the terms of the HELOC. For example, lenders may include prepayment penalties or account closure fees. Keep this in mind if you are considering selling your property while your credit line is open.
Use the HELOC Wisely
Spend some time thinking about why you are applying for HELOC for your rental property and how you intend to use the funds.
For example, one way to profit from a HELOC is to use the money to build an addition on your property. You may also use the funds to add a finished basement or a garage, both of which may increase the value of your place and increase the resale value.
Be prepared to go through multiple appraisals when applying for a HELOC for your rental property. The appraisal process can be much more aggressive than it is when applying for a conventional mortgage. As such, you may need to be patient and pay for numerous inspections during the process.
One of the downsides is that if you’re denied a credit line, you don’t get the money for an appraisal back — meaning you could lose hundreds of dollars in appraisal fees.
HELOC Alternatives to Consider for Your Rental Property
The more you look at a HELOC loan, the less attractive it may seem due to the rigorous inspection process and high costs. This isn’t the end of the world, since there are plenty of other options available to fund your rental property.
Here are some alternative options to consider before going through the application process.
A cross-collateralization lets you group multiple properties together into a single loan. In other words, you can use another rental property to secure a loan for your rental.
As you make mortgage payments, you gain equity in your home. And as you do this, your home may increase in value.
A cash-out refinance enables you to leverage the equity in your home and let you take out cash in exchange for securing a larger mortgage.
You may have more luck and encounter fewer barriers by using credit cards to make capital improvements to your rental property. Look for cards with great interest rates and rewards.
If you secure a card with a 0% promotional interest rate, just remember to pay the card off before the grace period expires to avoid getting slammed with interest.
If you’re willing to deal with a higher interest rate, consider taking out a personal loan from a lender.
The loan most likely won’t come with any restrictions and you may be able to qualify for more than you would with a HELOC. Plus, the approval process is much less aggressive.
Sell Your Property
If all else fails and you can’t secure the cash you need for your rental property, you could always sell it. After all, real estate investors are often looking for fixer-uppers, which means you may be able to arrange a quick sale even if the house needs work.
Another option is to exchange your rental property in a 1031 exchange, which allows you to trade your property for another investment of equal or greater value. For example, you could swap your rental property for a portfolio of rentals.
Frequently Asked Questions
Can you use a reverse mortgage on a rental property?
A reverse mortgage is a mortgage loan that allows the borrower to exchange home equity for regular payments. This is often done to supplement retirement income.
Unfortunately, you can’t use a reverse mortgage on a rental property or a part-time residence. To qualify for a reverse mortgage, you must apply it to the property that is your primary residence throughout the year. As a result, this does not apply to investors.
Is a Home Equity Loan a HELOC?
A home equity loan is similar to a HELOC in that it can be used to secure funding for a property. However, home equity loans have fixed payments and fixed interest rates. Home equity loans are also distributed in lump-sum payments while HELOCs allow you to draw money on an as-needed basis.
Do you need a strong credit score when applying for a rental property HELOC?
If you’re applying for a HELOC for a rental property, the lender will want to see a demonstrated ability to pay back what you borrow. While there is no set minimum for a HELOC with a rental property, you should have a score of at least 720 or higher just to be safe. The lender may reject you if your score is not up to par.
That said, you can usually fix a low credit score by making credit card and loan payments on time and lowering your revolving debt. So if your credit score is low, work on improving it before applying for a HELOC.
Are HOA fees calculated in a DTI calculation?
Homeowners Association (HOA) fees are typically calculated in a front-end DTI ratio. If you live in a condo or apartment with an HOA, you may have a higher DTI.
The Bottom Line
Applying for a HELOC can help you get funding to pay for expenses on your rental property. If you can secure a HELOC from a lender, you have the freedom to use what you borrow as you need to, without restriction, during the draw period — and you may be able to get a better interest rate than what you will find on a credit card or personal loan, too.
That said, HELOCs also come with some major drawbacks.
For example, you will lose some of the equity that you’ve put into your property until you’ve repaid the line in full, plus interest. On top of that, HELOCs can be very expensive thanks to closing costs.
If you need money badly enough to apply for a HELOC, it’s a good idea to explore your other options. Don’t move forward with a HELOC unless you’re in a position to take on the loan. Otherwise, you may end up biting off more than you can chew, transforming your rental property from a potential source of income to a massive money pit.
Here’s to making the best financial decisions for your real estate investments!