Should you take equity out of an investment property?
There are many reasons why you might want to tap into the equity of an investment property. Here are some important factors to consider before you do.
Pros and cons
Reasons you should (and shouldn't)
Best ways to tap equity
If you have money tied up in an investment property, you might wonder whether unlocking some of that equity is a good idea.
There are many reasons to consider taking out a loan against that second home you're renting out long-term, using as an Airbnb property, vacation home, or short-term rental.
Taking equity out of an investment property could be wise if the risks don't outweigh the rewards.
Pros of taking equity out of an investment property
As a real estate investor, you want to get as much out of your assets as possible. Any money you have locked up in a property's equity is unproductive and could be used to your benefit.
U.S. home values increased by nearly 20% in 2021, so now might be a great time to cash out some of the equity you've built in your investment property and put that money to work for you.
If you qualify for an investment property equity loan, you can use the cash for any purpose, including a down payment for purchasing more investment properties. Depending on how you use the funds, you can take advantage of some tax benefits.
Borrowing equity can be an excellent strategy for growing your real estate portfolio or diversifying your investments. Or, if you need quick access to cash flow, taking equity out of an investment property can be a great way to access funds at a lower interest rate than with a personal loan.
Cons of taking equity out of an investment property
Of course, taking out a loan secured against property always comes with risk. When you borrow against your home equity, your property becomes collateral, and you could lose your real estate investment to foreclosure if you cannot repay the loan. While you won't be risking your primary residence, foreclosing on a second home would still be a significant setback for your finances. So it's essential to do your due diligence beforehand to ensure you won't end up in this situation.
Taking out an investment property equity loan might also require paying various closing costs, just like when you purchase a property.
Paying off the balance of another loan might also increase your monthly expenses and could cost you a lot in interest payments over the long run, especially if rates continue to rise.
When should you take equity out of an investment property?
Not all reasons for unlocking equity from an investment property are worth the downsides of taking out another loan. When considering reasons for pulling equity out of an investment property, you can rank them from okay to very risky.
Taking equity out of an investment property might be wise if you use the funds to reinvest your existing assets or improve your current mortgage or financial situation. For instance, you might want to consider using the equity you've built in your property for the following purposes:
- Home renovations: All properties require regular maintenance, and over time, you will need to replace more expensive items, like appliances, flooring, and windows. As your property's condition deteriorates, your home's value may also decrease. Using the equity in your investment property to make home improvements, you can preserve or even increase its value. Keeping your property in good condition will make it more appealing to tenants, who may be willing to stay there for longer. If you substantially improve the state of the property, you will also be able to charge higher rental rates, resulting in greater returns on your investment over time.
- Consolidating high-interest debt: Mortgages offer much lower interest rates than credit cards and other debt financing options. By paying off higher-interest sources of debt with a cash-out mortgage, you might save hundreds if not thousands of dollars in interest over the long term. However, many investors make the mistake of consolidating their debt only to run up the balances on their high-interest lines of credit once again, leaving them with an even greater debt load to manage. If you are considering using an investment property equity loan to consolidate your debt, make sure that you will have enough operating capital so that additional borrowing won't be necessary.
- You need help and don't want to sell your home: If you're struggling to make ends meet during retirement, or you've lost a tenant and can no longer afford mortgage payments, tapping home equity can provide breathing room to improve your financial position. If you have a sound exit plan or a clear path to rebuilding your home equity, going this route may be preferable to you than selling your investment property.
While a little riskier, using equity from your investment property to invest in your future earning potential might be a strategy that ends up paying off. Although, it would be prudent to have adequate cash reserves should your position be impacted by market dynamics. For instance, you might want to consider tapping into your investment property equity for the following purposes:
- Purchasing a rental property: After weighing the pros and cons, a home purchase might make sense if the property would generate enough rental income to offset costs, including new mortgage payments.
- Paying for college: If you're confident that investing in more education will set you up for more significant future financial success, the opportunity costs might be worth it.
Very risky reasons
It would be best if you never pulled equity out of an investment property to make expensive personal purchases that won't help improve your financial situation. Taking out equity to reinvest it in your business, eliminate personal debt or invest in your future earning potential will have very different outcomes than using equity for things that don't contribute to your financial success, such as:
- Going on vacation
- Buying a new car
- Making bets (gambling, cryptocurrency, meme stocks)
You may think that using an investment property's equity to pay for a dream vacation, luxury item, or entertaining gamble will keep you from paying extra for these things, but that might be a costly assumption. You should always carefully weigh the costs of taking out a loan against expected future income and walk away from any strategy that would increase your debt-to-income ratio (DTI) without solid numbers to back it up. There are many good reasons to put equity from an investment property to work. But sometimes, leaving it untouched is the best move.
If you take equity out of a second home and use the money to buy, build, or improve an investment property, you can write off a portion of the interest you pay.
However, the Tax Cuts and Jobs Act of 2017 recently changed many rules for claiming tax deductions on mortgages and home equity loan interest. For instance, under the new legislation, in effect through 2025, interest on a home equity line of credit (HELOC) for renovations can be tax deductible only if the proceeds "substantially improve" a qualified residence. To be eligible for tax benefits, the project in question must add to a property's value, prolong its useful life or adapt it for new uses.
Before taking equity out of an investment property, you should get professional advice to ensure you take advantage of all possible tax advantages.
Four ways to take equity out of an investment property
Homeowners have more ways to take equity out of an investment property than ever. The best option for you depends on your financial situation, your property's equity, your desired loan-to-value ratio (LTV), and how you plan to use the funds.
If you don't want monthly payments
If you're looking for a loan you won't need to start paying back immediately, the Fraction Mortgage might be a great solution. The Fraction Mortgage is an innovative home equity line of credit with no required monthly payments.* Because it's an open line of credit, you have the flexibility to make payments at your own pace, and you can redraw those amounts at any point while still in the draw period. How you choose to repay the Fraction Mortgage during the loan term is entirely up to you. You can make consistent payments or wait until the end of the term to pay off the balance and interest owing all at once. You can also choose to exit the mortgage if the opportunity to refinance at a lower interest rate presents itself anytime within the 5-year term. If you wish to continue the arrangement once the period ends, you might also have the option to renew for another term.
If you have ongoing projects
For property owners who 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. 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. While HELOCs tend to offer a higher maximum LTV than other loans, HELOCs on investment properties are generally stricter and come with higher interest rates.
If you don't want to manage another loan
A cash-out refi provides the option of refinancing an existing mortgage to a new loan with a higher loan amount and keeping the difference in cash. Instead of taking out a separate home loan on your investment property, the remaining loan balance on your primary mortgage would get paid off and rolled into a new mortgage with a more extended repayment period and interest rate.
Home equity loan
If you want consistent monthly payments
A home equity loan is a large, lump-sum cash payment that must be paid back in fixed installments over a predetermined period. This type of loan comes with a fixed interest rate, which keeps payments consistent over the entire term. It's 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.
Which loan has the lowest monthly payments?
The Fraction Mortgage does not require monthly payments, which can be attractive to borrowers trying to optimize cash flow while managing multiple properties. Just remember, if you choose not to make any payments throughout the mortgage, you'll still have to pay off the balance and all interest owing at the end of the 5-year loan term.
Which loan is easiest to qualify for?
An investment property equity loan is usually easiest to get through a cash-out refinancing, even with a poor credit score.
Qualifying for a Fraction Mortgage should be relatively easy as long as you have a fair credit score.
Unfortunately, if you want a traditional HELOC, only a few lenders are willing to offer this product for a second home, and those who do usually have stringent approval requirements. Qualifying for this type of loan can be tough with an investment property.
A home equity loan can also be challenging to access with investment properties and typically come with higher interest rates.
Which loan has the lowest rates?
If you qualify for cash-out refinancing, you can typically access lower interest rates than a HELOC or home equity loan since this type comes with standard mortgage rates. You might also benefit from tax deductions resulting in further savings after refinancing your investment property.
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.