How to Leverage Your Home Equity to Buy Rental Property
June 14 2022 Posted by Guriqbal Chahal, MBA, PMP
Getting approval for a mortgage to buy your own home is challenging, but it does not compare to the difficulty of getting a loan to buy a rental property. Loan requirements for investment properties are more difficult than those for a private residence. This is why most people stop their property ownership journey with buying their home.
However, if you have owned your current home for a while, you may already have what you need to buy an investment property. You don’t need to go through the demanding process of qualifying for a loan in order to buy your first rental property. Instead, you can use home equity to finance your dream of becoming a landlord, suggests Leenan Properties.
What is home equity?
Home equity is the portion of your home that actually belongs to you. The truth is, when you buy a home using the mortgage, you are only part-owner of the property. Although you control the home, the mortgage provider owns a big portion of the property.
At first, your share of the property is determined by your down payment which is the percentage of the home’s purchase price that came out of your pocket. The bank’s share is the money they gave you to make up the sales price of the home.
Your share of the property is referred to as your home equity. It is the amount of money you will receive if your home was sold today. Home equity grows in two important ways; your mortgage payments and market appreciation.
If the home’s value was $400K when you bought it and you paid a 10% down, your original equity in the home would be $40K. By diligently paying the mortgage, you reduce the bank’s share of the home and increase yours.
As an example, after some years, your equity may have grown to $150K. At the same time, the market value of the home has risen to $600K. Your equity in the home would now be its market value ($600K) minus your remaining mortgage ($250K) to make it $350K.
If you sold that home today for $600K; after the bank removes the balance of the money you owe them, $350K is what you would get. But, if you did not sell your home, you could still use that equity to finance the purchase of another property.
Financing a rental property by leveraging your home equity
This is because lenders will let you borrow money when you secure it with your home equity. Lenders like this arrangement because the loan is secured by a tangible asset; your home. In the event of default, they know they won’t lose their money.
Home equity loans are based on the current market value of your home. Lenders will appraise your home to determine its Fair Market Value (FMV). After deducting the balance of your mortgage from the FMV, they will let you borrow up to 80% of the property’s value.
This means, if your home equity is $350K, you can borrow as much as $280K. The best part is there are no restrictions on what you can do with this money. However, probably the best way to use a home equity loan is as a down payment on an investment property.
Types of home equity loan
There are three ways a home equity loan may be structured:
· A second mortgage
This is like your first mortgage, except that you use your home as collateral for the loan. A second mortgage means you have two mortgage payments to make every month; the original mortgage and the second one.
With a second mortgage, the lender pays a lump sum into your account and you may withdraw all of the money at once. This is the preferred option when buying rental property.
· Home equity line of credit (HELOC)
A HELOC works the same way a credit card does. It puts a sum of money at your disposal, which you can borrow from, up to the credit limit. With a HELOC you are expected to borrow from the loan and repay it repeatedly. You only pay interest on the money you borrow, not the entire loan amount. This option is best for investors who want to flip houses.
· A reverse mortgage
This type of home equity loan is not relevant to the discussion because it can’t be used to finance a rental property.
Why you should use home equity financing
Home equity financing helps you unlock the full potential of your home as an instrument for building wealth. It is one of the ways the financial system rewards homeowners who have been faithful in paying the mortgage on their first home. It makes it easier for them to acquire more properties in addition to that first home.
When you leverage home equity to finance a rental property, you:
- Avoid the burden of saving for the down payment on that property
- You acquire an income-generating asset that will pay for itself
- Your monthly expenses do not increase because the rent from the rental pays the mortgage.