How to Use Equity in a Rental Property

There are a variety of reasons why people like owning their own homes. Homeownership can provide financial security, stability, potential tax benefits, and the ability to create a personalized living expression.

Then there is the equity that can be built, over time. Some homeowners might be content to let that equity grow and collect it when they sell the house. Others might decide to tap into that equity through a home equity loan or refinance process.

Homeowners in the latter category could use that extra money for debt consolidation, educational expenses, or home repairs. Or they might decide to use that equity to purchase and/or invest in a rental property. 

Borrowing Against the Home

Equity is defined as the market value of a particular asset minus the value of liabilities on that asset. In this case, “liability” can mean “home mortgage.” For example, if an investor’s home has a market value of $850,000 secured by a $400,000 mortgage, the overall equity would total $450,000. 

There are generally two methods used to tap into home equity:

Home Equity Line of Credit (HELOC)

As its name suggests, a HELOC is a revolving line of credit. Think consumer credit card, but one that uses a home’s equity as collateral. Lenders will examine the equity amount available, as well as the borrower’s credit score and debt-to-income ratio. HELOCs generally come with adjustable, or variable, interest rates. 

Home Equity Loan

Sometimes known as a second mortgage (generally with a fixed interest rate), home equity loans allow homeowners to borrow a percentage of their home’s equity. The borrower receives a lump sum, which is paid back to the lender in installments. 

Many lenders only allow a homeowner to borrow up to an 80% combined loan-to-value ratio (CLTV). This means that the primary mortgage loan and home equity loan can’t exceed 80% of the home’s value.

The Rental Investment

The lump sum payment from a home equity loan can help a borrower buy or invest in a rental property. The benefits of using this type of financing to buy a rental property include:

• A large amount of cash for a higher down payment or to purchase the rental property in full 
• An ability to keep cash and emergency savings intact
• The potential of borrowing money at a more competitive rate
• Better budgeting, as repayments are spread over time
• Using the equity of one asset to build wealth by investing in another

But using homeowner’s equity for rental property investments could also create the following problems:

• Repayment of up to three mortgages: the original home mortgage, the home equity loan, and any financing taken out on the rental property
• Possible falling property values, meaning the borrower could owe more than the original home – and rental property – is worth
• The primary home is at risk; as that home is used as collateral, the borrower could lose it if they fall behind or default on payments

The Takeaway

It’s possible to use equity in one real estate asset (like a primary residence) to invest in or buy a rental property. While there can be benefits to this method, it’s also important to understand the drawbacks. Before heading on this course, it’s a good idea to talk to an expert in the field.