When thinking of buying your first rental property, the number one obstacle you have to scale is saving up enough money to make the down payment on the property. The down payment requirements are a lot easier when buying your primary residence than when borrowing to buy an investment property.
In the typical scenario, lenders will not ask for more than a 10% down payment when you are buying the home you will live in. Sometimes, such as when buying your first home, the down payment can be as low as 0 - 3%. That is if you use options like HomeReady and Home Possible or get an FHA loan.
But for rental properties, the down payment is between 15 - 25%. The exact amount depends on factors such as your credit score. The point is, says JTS Property Management, buying a rental property is more difficult than buying your own home. That’s why a lot of would-be property investors never see their dreams take flight.
However, there is a way to get around the issue of saving up enough money to make the down payment on a rental property. This is an option you can use if you already own your own home and have been living in it for a while. You could use the built-up equity in that home to buy your rental property.
It is possible to leverage the equity in your home to finance the acquisition of a rental property. This will typically involve taking out a Home Equity Line of Credit (HELOC) or Home Equity Loan on your home and redirecting the money into a rental property. How does this work?
What is home equity?
In the simplest terms, your home equity is the value of your home less the amount you owe on it. It is how much you would get if you sold the home today after the bank has taken out the money it gave you to buy the property. Your home equity is constantly going up in two ways.
● Home equity grows as you pay off the mortgage on your home. When you bought the home, your equity equaled the down payment you made on it. But your share in the home increases, while the bank’s share decreases, as you repay that loan. To build up reasonable equity in your home, you need to have made these payments for at least 5 years.
● Home equity also grows as the property appreciates in value. Appreciation happens as a result of market forces and improvements you make to the home. Your home will be more valuable if you enhance its function and aesthetics. Your home is also likely to increase in value due to market forces. This depends on the condition of the housing market in your area.
To leverage the equity in your home you simply trade in your built-up equity in the property for a loan that puts cash at your disposal. That money can now be used as a down payment on the rental property. Is this a good idea? How does the process work? What are the risks?
Here is how to buy a rental property by leveraging your home equity.
How home equity works
To explain how home equity loans work, let's use an example. Say, for instance, you bought a home with a market value of $300,000 and made a down payment of 10% on the property. Your initial investment would be $30,000 and the lender will loan you $270,000 to enable you to buy that property.
That gives you a 10% stake or $30,000 equity in the home.
Fast forward to 5 years and after making the mortgage payments on time, you now only owe $150,000 on the home. Also, in that period the home’s value has jumped to $330,000. Your home equity would be $180,000 which is computed as the current market value of the home less what you owe ($330,000 less $150,000).
Since your equity in the property would be $180,000, this is how much you can potentially borrow to buy your rental property, although lenders will usually not let you borrow more than 80% of the equity on the home. This means you can realistically borrow $144,000 on the property.
Here are the steps to do that.
1. Determine your available equity
To determine your home equity, you need to know the current value of the home and the balance on your mortgage. You can get an idea of how much the property is worth by using an online real estate appraiser. To check the balance on your mortgage, go to your mortgage provider’s website and log into your account to retrieve the information.
2. Choose your loan option
The two main loan options you have when leveraging your home equity are Home Equity Loans and Home Equity Line of Credit (HELOC). Each option has its advantages, depending on the kind of property investor you want to be.
● Home equity loans
With a home equity loan, the lender pays the loan amount into your account in a single payment as soon as the loan closes. This type of loan is like a second mortgage. Like your first mortgage, you will pay back the loan in monthly installments. A home equity loan is the better option if you are a buy-and-hold property investor.
● Home equity line of credit (HELOC)
This is similar to a credit card; the lender pays the loan amount into your account. You can draw money from the account and repay it as often as you want. Interest is only charged on the amount you draw from the account. HELOCs are a better option if you plan on flipping houses.
Assessing the risks
What are the risks involved when you borrow on your home equity?
● You will be taking on more debt and that can put a strain on your finances. However, the monthly income from your rental should be able to cover the mortgage payments on the investment property, with some money left over.
● You will be putting your home at risk because borrowing against your home equity literally means you are using your home as collateral. If the investment goes awry there is a chance that you could lose your home.
● If you fail to keep up with the payments on the home equity loan, your credit score will take a hit. This will severely narrow your financial opportunities in the future.
That being said, leveraging your home equity is a great way to get started as a property investor. But to avoid mistakes during the process it is a good idea to speak with an experienced mortgage broker before you take this step.