Best ways to take home equity out of a rental property

If you’ve savvily invested in a second home, you might wonder how to use the equity in your real estate investment while using it as a rental property.

As every investor knows, time is money, and you’re probably already well aware of the usual ways to benefit from a rental property over the short and long term.

Currently, your investment property is likely either providing a steady stream of cash flow from monthly rental income, increasing yearly with rising rents, or from bookings as a vacation property. Meanwhile, as you plan for your future, you’re likely factoring in the profits you’ll make once you ultimately decide to put the property up for sale.

But for the time being, all the money locked up in your rental property’s home equity isn’t being used. Frustrating, right?

Fortunately, you have options.

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1. Fraction Mortgage

The best option for better cash flow

If you’re looking for a loan that doesn’t require you to start paying it back immediately, look no further than the Fraction Mortgage.

The Fraction Mortgage is an innovative home equity line of credit with no required monthly payments.* By taking equity out of a rental property with a Fraction Mortgage, you can optimize cash flow to cover the cost of ownership or even use the funds to invest in another property.

Since the Fraction Mortgage is an open line of credit, you can make payments and redraw those amounts while still in the draw period. There’s no limit to how you repay the Fraction Mortgage during the loan term; you can make consistent payments or wait until the end of the 5 year term. If you wish to continue once the term ends, you may have the option to renew for another term. 

But the benefits of the Fraction Mortgage don’t stop there.

The Fraction Mortgage can also be a helpful tool for weathering economic uncertainty. For starters, Fraction bases your interest rate on the appreciation of your property, which can protect your equity if the market shifts. At a time when The Fed’s rising rates are putting downward pressure on home prices, an appreciation-based interest rate could work in your favor. 

Moreover, since there are no prepayment penalties with a Fraction Mortgage, you could choose to exit the mortgage if the opportunity to refinance at a lower interest rate presents itself within the 5-year term.

Granted, just like any loan secured against property, the Fraction Mortgage does not come without risk. If you cannot repay the loan at the end of the term, you may risk losing your property.

If you want to optimize cash flow and gain protections for your equity against market shifts, then the Fraction Mortgage may be the right choice.

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2. HELOCs

The best option for projects

If you want to be able to withdraw funds for unplanned purposes over a long period, a home equity line of credit (HELOC) might be a good fit for you.

Like a home equity loan, a HELOC is a second mortgage. But instead of lending you one large lump-sum amount upfront, a HELOC allows you to borrow money only when you want to, and your monthly payments are based only on the credit you use — similar to a credit card.

A HELOC is a revolving line of credit typically consisting of an initial draw period of 5 to 10 years and a repayment period of up to 20 years. The exact timing and terms of the loan will vary depending on your lender and the amount of money you are approved to borrow.

During the draw period, you will have the leeway to take out as much or as little money as you want, up to a maximum loan amount, and you’ll only need to make minimum payments to cover the cost of interest. Once this period ends, you’ll need to start paying back all the borrowed money and the interest on the outstanding loan amount.

While a HELOC can be a great way to convert some of the equity in your rental property into cash at the pace you need, only a few lenders offer this product for second homes.

Any reputable lender willing to provide a HELOC for your investment property likely has stringent approval requirements, and you might need help qualifying.

If you can find a lender willing to approve you for an investment property HELOC, make sure to seriously consider the downsides before moving forward.

First, taking out a HELOC puts your investment property at risk. In this case, you won’t be risking your primary residence, but foreclosing on your second home would still be a significant financial setback. It would mean losing your investment and all the future income you could’ve earned from your rental property.

Unlike a home equity loan, a HELOC on an investment property typically comes with a variable interest rate. Your interest rate will increase or decrease over the loan term as the market fluctuates, making it difficult to anticipate how much you’ll owe on each payment.

Lenders will probably see you at a higher risk of defaulting with your cash flow tied up in multiple properties. For that reason, they’ll likely also charge you more in fees and interest.

So if you choose this strategy for taking equity out of your rental property, pay close attention to how much your lender requires that you pay back and ensure it’s worth your while.

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3. Cash-out refinance

The best option for low rates

Cash-out refinancing provides the option of refinancing your investment property with a higher loan amount and keeping the difference in cash.

If you’re concerned about your ability to juggle two mortgages on your second home, this might be a good choice. Instead of obtaining a separate investment property loan, the remaining balance on your primary mortgage gets paid off and rolled into a new mortgage with a new term and interest rate.

If you qualify for cash-out refinancing, you can typically access lower interest rates than with a HELOC or home equity loan. You might also benefit from tax deductions resulting in further savings after refinancing your investment property.

But remember that you usually need to pay closing costs when you refinance, just like when you buy a home. Some typical closing costs include credit report fees, appraisal, and attorney fees, depending on your state. If you only want to access a small amount of funding through a cash-out refinancing, consider whether the closing costs outweigh savings from a lower interest rate.

Also, replacing the current mortgage on your second home with a new and larger one might mean you’ll need a longer time horizon to pay it off. 

You may pay more interest in the long run, especially if rate hikes force you into taking on a higher interest rate than the one available when you initially enter a cash-out refinance agreement. If you decide this is how you want to unlock equity from your investment property, take a close look at the Closing Disclosure from your lender and feel entirely comfortable with your new loan terms.

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4. Home equity loan

The best option for consistent payments

A home equity loan provides borrowers with a large, lump-sum cash payment that they must pay back in fixed installments over a predetermined period.

It can be a great option if you want immediate access to a large amount of money and know how much to budget to pay back the balance and interest on the loan. Since home equity loans come with fixed interest rates, your payment amounts will remain consistent over the entire term.

Similar to a HELOC, some of the main disadvantages to a home equity loan are that they can be difficult to access for rental properties and typically come with higher interest rates. You will also need to pay various closing costs, just like when you purchase a property.

Obtaining a home equity loan involves taking out a second mortgage, which means you will need to make additional loan payments on top of your regular primary mortgage payments. You could be at risk of foreclosure if you can’t keep making these extra payments and end up defaulting on the loan. Also, keep in mind that when you sell your investment property, you’ll have to pay off the outstanding balance of your home equity loan — in addition to the remaining balance of your primary mortgage — as soon as you close.

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Looking for a reverse mortgage? You may be out of luck.

A reverse mortgage is a non-recourse loan secured against your primary residence with no monthly payments required.* Unfortunately, since only primary residences can qualify for this type of loan, a reverse mortgage on a rental property is simply out of the picture. 

However, if you like the concept of a reverse mortgage and wish to get approved for one for your rental property, a Fraction Mortgage might be an even better alternative.

The Fraction Mortgage presents similar benefits to a reverse mortgage, but you can qualify at any age with a primary, secondary, investment, or rental property. Like a reverse mortgage, the Fraction Mortgage does not require any monthly payments, which can be attractive to borrowers trying to optimize cash flow while managing multiple properties.

There are some trade-offs. For example, a Fraction Mortgage is not a non-recourse loan, so the balance owing could exceed the home value, leaving the borrower on the hook to make up the difference (but we do our due diligence to avoid these situations). 

One way we protect homeowners from this happening is by using appreciation-based interest rates. If their home appreciation accelerates, their interest rate goes up, but if their home appreciation decelerates, their interest rate goes down. This mechanism can help protect your home equity from being eroded if you decide a Fraction Mortgage is right for you.

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How much equity do I need in my rental property to start borrowing?

To find this out, look at the loan-to-value (LTV) ratio of the different loan products you’re considering.

For example, an investment property HELOC typically requires a maximum 80% LTV ratio, meaning you will need at least 20% equity in your rental property to get approved. However, lenders who may approve an LTV of 80% for a primary residence may require 70% or less LTV for a rental property.

Keep in mind, when looking into options for unlocking the home equity you’ve built up in your rental property, you will want to know more than whether or not you qualify. Just as necessary is the amount of money you can access. Your potential loan value can vary significantly, depending on factors ranging from your current income to your credit score to your geographic location. Different types of loans from various providers can impact the amount you can access. And there are also ways you can improve your finances to qualify for even more cash.

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Disclaimer: Information in this article is general in nature and not meant to be taken as financial advice, legal advice or any other sort of professional guidance. While information in this article is intended to be accurate at the time of publishing, the complexity and evolving nature of these subjects can mean that information is incorrect or out of date, or it may not apply to your jurisdiction. Please consult with a qualified professional to discuss your specific situation and confirm any information.