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 be wondering 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.
As long as the risks don’t outweigh the rewards, taking equity out of an investment property could be a smart move.
Pros of taking equity out of an investment property
As a real estate investor, you ideally want to get as much as possible out of your assets. Any money that you have locked up in a property’s equity is unproductive and potentially could be put to better use.
U.S. home values increased by nearly 20% in 2021, which means 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’re able to 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 might even be able to take advantage of some tax benefits.
This can be a great strategy for growing your real estate portfolio or diversifying your investments. Or if you just 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 some risk. When you borrow against your home equity, your property becomes collateral, and you could lose your real estate investment to foreclosure if you’re unable to pay back the loan. While you won’t be risking your primary residence, foreclosing on a second home would still be a major setback for your finances. So it’s important 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 end up costing 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 that come with 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 a smart decision if you are going to use the funds to reinvest in your existing assets or improve your current mortgage or financial situation. For instance, you might want to consider using 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 the condition of your property deteriorates, the value of your home may decrease as well. By using the equity in your investment property to make home improvements, you will be able to preserve or even increase its value. Keeping your property in good condition will make it more appealing to tenants, and they may be willing to stay in the property for longer if it’s being updated on a regular basis. If you substantially improve the condition 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 types of debt financing options. By paying off higher-interest sources of debt with a cash-out mortgage, you might be able to 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.
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 for you 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 greater future financial success, the opportunity costs might be worth it.
Very Risky Reasons
You should never pull 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 end up being a very expensive 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 smartest move.
If you take equity out of a second home and use the money to buy, build, or improve an investment property, you might be able to write off a portion of the interest you pay on the loan.
However, the Tax Cuts and Jobs Act of 2017 recently changed many of the 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) being used for renovations can be tax deductible only if the proceeds are used to “substantially improve” a qualified residence. That means to get tax benefits from using home equity for renovations, a project 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 might want to get professional advice to ensure you don’t miss out on any possible tax advantages.
Four ways to take equity out of an investment property
These days, homeowners have more ways to take equity out of an investment property than ever before. The best option for you depends on your financial situation, the amount of equity in your property, your desired loan-to-value ratio (LTV), and how you plan to use the funds.
1. Fraction Mortgage
If you don't want monthly payments
If you’re looking for a loan that you won’t need to start paying back right away, 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 also entirely up to you. You can make consistent payments or wait until the end of the term to pay off the entire 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 term 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 of time, 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 gives you the flexibility 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.
3. Cash-out refinance
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 longer repayment period and interest rate.
4. 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. This 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.
Which loan has the lowest monthly payments?
The Fraction Mortgage does not require any monthly payments, which can be attractive to borrowers who are trying to optimize cash flow while managing multiple properties. Just remember, if you choose not to make any payments over the course of 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 cash-out refinancing, even with a poor credit score.
As long as you have a fair credit score, qualifying for a Fraction Mortgage should also be relatively easy.
Unfortunately, if you want a traditional HELOC, very 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 very difficult with an investment property.
A home equity loan can also be difficult 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 with a HELOC or home equity loan, since this type of loan is tied to standard mortgage rates. You might also be able to benefit from tax deductions resulting in further savings after refinancing your investment property.
Access investment property equity with Fraction
Looking for a flexible way to take equity out of an investment property? With no required monthly payments*, no age restrictions, and no exit penalties, the Fraction Mortgage may be the right solution for you.
Get your free estimate today.
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.