Leverage is a powerful tool real estate investors use to boost potential returns and increase the number of rental properties owned.
Many people associate leverage with OPM, or “other people’s money.” However, you can also access the accrued equity in your existing rental property by using the collateral to take out a second mortgage.
One popular way of tapping into the equity in your investment property is by using a home equity line of credit (HELOC).
What is a HELOC?
A HELOC is a popular tool that real estate investors use to draw on the equity in their rental property.
Unlike a home equity loan (HEL) where funds are received in one lump sum, a HELOC acts as a type of revolving line of credit against the equity in your property. You don’t have to draw on it right away, but you know the money is there if and when you need it.
Is it possible to get a HELOC on a rental property?
Lenders love to make loans to successful real estate investors. Rental property owners can be a great source of recurring fee income and interest payments for a lender.
Getting a HELOC on your existing rental property can be done but, until you have a proven track record with your go-to lender, you may have to jump through more hoops. That’s because home equity lenders are becoming more strict with their lending criteria, with a laser-sharp focus on your ability to make all monthly payments on time over the entire repayment period.
Let’s look at some of the benefits of getting a HELOC and review the steps you should take to get a “yes” from your lender when you’re shopping around.
Benefits of getting a HELOC on your rental property
Having the ability to draw on the existing equity in your rental property by using a HELOC can be a great way to have access to funds when and if you need them. Some of the benefits of getting a home equity line of credit on your investment property include:1. Finance improvements or upgrades
Using a HELOC to update your rental property and increase your monthly rental income is one great way to put a home equity loan to work for you. Your monthly cash flow may increase, along with the market value of your property and your deductible interest expenses, even after making the minimum payments.
That’s because the greater the net operating income (NOI), the more your property will be worth. For example, let’s say your current NOI is $10,000 per year and cap rates for single-family rental (SFR) houses like yours are 6%.
Using a HELOC to make improvements that let you raise your monthly rent and boost your NOI by 10% would add $16,667 to your property value:
- NOI / Cap rate = Market value
- $10,000 NOI (before HELOC improvements) / 6% cap rate = $166,666 market value
- $11,000 NOI (after HELOC improvements) / 6% cap rate = $183,333
2. Add rentable square footage
Many real estate investors are surprised to learn how much equity they’ve accrued in their rental property over just a few years.
As an example, if you purchased an SFR property five years ago for $150,000 in a market where houses have appreciated 5% annually, your property would now be worth $191,442.
If you made a 20% down payment and financed the remaining $120,000, your outstanding first mortgage balance would be about $111,500, excluding any closing costs that may have been rolled in. That means the total equity in your property is now nearly $80,000:
- $191,442 current market value less $111,500 mortgage balance = $79,942
Now, if you used a HELOC to access part of your accrued equity to add rentable square footage by converting your attic or garage to a studio apartment, you could significantly increase the market value of your rental property.
Assuming the extra rental income for your additional space added $5,000 to your annual NOI, your property market value would be:
- $10,000 NOI (before using HELOC to add space) / 6% cap rate = $166,666 market value
- $15,000 NOI (after using HELOC to add space) / 6% cap rate = $250,000 market value
In addition to increasing your monthly cash flow by using a HELOC to add a new rental unit, you’ve also increased the market value of your property by more than $83,000.
3. Grow and diversify your investment portfolio
To be fair, adding rentable square footage simply isn’t an option for many SFR properties. Homeowner association (HOA) restrictions, zoning laws, or the floorplan of the house may make converting an attic or garage unrealistic or not cost-effective.
Many investors overcome that obstacle by becoming long-distance real estate investors. By using a HELOC to fund the down payment on another SFR in a different part of the country, they’re able to geographically diversify their investment portfolio and invest in smaller, secondary markets where yields are potentially greater.
Owner-occupied vs. rental property HELOCs
In general, getting a HELOC for your rental property will cost more in upfront fees and monthly interest payments. That’s because banks see a higher default risk with investment property, or non-owner occupied property, than with an owner-occupied residence.
In addition to a higher potential risk of default, home equity lines of credit are usually in second or third position.
You’ve probably heard the phrase “first in line, first in right.” A HELOC isn’t normally the first in line, so the lender runs a higher risk of not getting repaid if the borrower defaults, because other liens are getting paid first.
Here’s how HELOCs on owner-occupied property differ when compared to HELOCs on rental property:
Owner-occupied HELOC primary residence
- Higher LTV (loan to value) allowed, sometimes up to 80% LTV
- Lower interest rate
- No or low capital reserve requirement, which is money set aside for emergencies
- Appraisal process similar to a regular mortgage loan
Non owner-occupied HELOC investment property
- Lower LTV required, sometimes 75% but usually 70% loan to value or less
- Higher interest rate
- Required capital reserve account for repairs or tenant vacancy
- Possible requirement for multiple appraisals and a 12-month waiting period from the initial purchase
What to do before applying for a HELOC
There are a few things to consider before applying for a HELOC for a rental property:
LTV requirements: Lenders normally look for an LTV of 70% or lower for a rental property. In other words, you won’t be able to access all of the equity in your house as a line of credit because the lender wants you to keep part of the accrued equity in the property.
Credit score: Ideally, your credit score will be at least 740 when applying for a HELOC. Credit score is an indicator of how risky a borrower is. The stronger the score, the better the interest rate and terms—and the greater the odds of getting approved.
Cash reserve account: Real estate investors create cash reserve accounts as rainy day funds so cash is on hand for a costly emergency repair or an extended period of vacancy that creates short-term negative cash flow. Before approving a HELOC, many lenders require a borrower to have a cash reserve account with enough funds to cover several months – sometimes even a year or more – of operating expenses, including all loan payments.
DTI: Lenders look at your debt-to-income (DTI) ratio when evaluating the risk of making a HELOC loan. The better the balance between a borrower’s income and debt, the lower the risk to a lender. Normally, lenders look for a DTI between 40% and 50%. This means that if a borrower’s total gross annual income is $200,000 per year, the total amount of debt from items such as mortgages, credit card payments, student loans, and child support and alimony can’t be more than $80,000 to $100,000.
HELOC alternatives to pull cash out of a property
While there are definite advantages to taking out a HELOC on your rental property, there are also several other ways to access the accrued equity in your investment:
Home equity loan: The difference between a HELOC and a home equity loan (HEL) is that a HELOC serves as an open-ended credit line against your equity, while a HEL is a lump-sum payment that you receive right away.
Cash-out refinance: Refinancing the existing mortgage on your rental property by doing a cash-out refinance lets you pull much of the accrued equity out of your property. While lenders will still expect you to keep a certain percentage of the equity with the property, oftentimes fees and interest rates are lower with a cash-out refinance than with a HELOC or HEL.
Private loans: While it’s nice to be able to access the existing equity in your rental property, sometimes it isn’t possible or cost-effective. Private or personal loans are made by investors who will loan you money in exchange for a second-position lien on your property, secured by the existing equity. Depending on the private lender, fees and interest rates may be higher, and loan term lengths shorter.
Having access to capital is critical for doing deals and growing your rental property business. One popular way to access accrued equity is by taking out a HELOC on your rental property:
- HELOC is a line of credit used to access your accrued equity, similar to the way a credit card works.
- Getting a HELOC on a rental property is possible, although lender requirements are usually stricter than with owner-occupied property.
- Funds from a HELOC can be used for a variety of purposes, such as making improvements, building additional rentable square footage, or as a down payment for another investment property.
- Criteria lenders consider when reviewing a HELOC loan application include borrower credit score, LTV, and DTI.
- Alternatives to a HELOC include a HEL and cash-out refinancing.