What is a Home Equity Line of Credit (HELOC)?

Real Estate

Jul 31

If you are a real estate investor, you are always looking for ways to expand your real estate holdings. But one of the biggest obstacles that newer investors hit is saving sufficient capital to acquire that first or second rental.

One of the best tools in any real estate investors tool kit that can help you purchase additional rental properties is a home equity line of credit (HELOC).

Traditionally, when you think of a home equity line of credit you might think of someone looking to remodel their home or consolidate other high-interest debt. However, savvy investors have also discovered that home equity lines of credit can be a great way to leverage existing equity to fuel new acquisitions.

Recent data from credit repository TransUnion indicates that home equity originations increased to 1.2 million across the last quarter of 2021, which was a tangible increase from prior years. (National Mortgage News).

If you are one of the hundreds of investors curious about utilizing a new home equity line of credit for the purchase of a new rental property, here are a few things you should consider before committing to any new financing.

How Does a Home Equity Line of Credit Work?

A home equity line of credit (HELOC) is a lot like other types of mortgages in that it's a type of home loan that uses a residential property as collateral to secure the debt.

The biggest difference is that, unlike closed-ended mortgages, a home equity line of credit is revolving. Think of it like a secured credit card. You can draw from it as needed and as you pay down the principal balance owed, you free up more accessible funds.

The amount of credit you can obtain with a home equity line of credit depends on how much available equity you have available in your property.

Typically, you are only required to make interest-only payments for the term of the loan on any outstanding, unpaid principal balance, although there are some lenders that offer HELOCs that have a designated draw period in which the line is revolving, after which any unpaid balance is converted to a term loan.

It's also a common misconception that you must own your property free and clear to be able to open a new HELOC. In fact, it's from this standpoint that many borrowers associate home equity lines of credit as second mortgage products.

However, the truth is that HELOCs can actually take first, second, or sometimes even third lien positions on a property, depending on what your lender’s requirements are.

Home equity lines of credit are usually variable mortgages, meaning your interest rate is subject to change based on what’s going on in the market. The rate is often represented by some benchmark indices plus or minus a margin.

In most cases, lenders do not charge prepayment penalties on home equity lines of credit, although that doesn’t mean they can’t. Many lenders do charge annual fees as part of having the open line, similar to some credit card providers.

Before you open a brand-new home equity line of credit, make sure to read all the terms and conditions so you fully understand what provisions might apply to you.

What Do You Need to Qualify for a New HELOC?

All lenders are a little different with their qualifying criteria for new home equity lines of credit. Most will require you to have at least 15-20% equity in the property.

That means that if the market value for your property is $200,000 and you already owe $150,000 on your first mortgage, you may only be able to take out $10-20,000.

Example:
$200,000 (market value) x 80%
= $160,000 - $150,000 (first mortgage)
= $10,000 (credit limit)

Lenders also have different credit requirements when qualifying you for a home equity line of credit. While many lenders often follow conforming conventional mortgage requirements, setting the minimum FICO score at 620, others can be more flexible or conservative.

Understand that to qualify for any new HELOC, you will have to demonstrate you earn sufficient income, have reputable credit, and have sufficient collateral.

Using a HELOC to Purchase an Investment Property

Buying a new rental property using a home equity line of credit doesn’t have to be overly complicated. In fact, using a HELOC for your next purchase can be quite advantageous, although it's not without its drawbacks.

Once you have been approved for a new home equity line of credit you can approach your purchase in one of two ways. The first way is that you can find a property that is listed within your credit limit. This will allow you to function as a cash buyer.

The second option is that you can use your HELOC to fund the down payment on a new rental and secure a separate mortgage loan for the remainder of the acquisition costs. This can be a bit riskier if your debt-to-income is already stretched thin.

Pros to Using a HELOC

There are many benefits to using a home equity line of credit for your next rental purchase. For starters, it allows you to be a more competitive buyer by allowing you to make cash offers.

Another reason a HELOC is a great investment financing tool is that it leverages existing real property, allowing you to retain cash and short-term equivalents, helping keep you liquid.

In fact, as you pay down your HELOC, it can be used to help pay for upkeep, improvements, or other property acquisitions. Depending on how you use the funds, in certain scenarios the interest you pay could even be tax deductible.

Cons to Using a HELOC

While using a HELOC to purchase an investment property is a smart move, it can have some drawbacks. One of the biggest downsides is that home equity lines of credit often have variable rates, meaning your payment could fluctuate monthly.

Another issue some borrowers have is that much like credit card debt, balances can easily snowball. Keep in mind that your HELOC is backed by your real estate, so if you miss payments or default, your lender can foreclose.

Lastly, understand that opening a home equity line of credit is not free. Like a first mortgage, there are closing costs that could include, but are not limited to, appraisal fees, title fees, and points. Make sure to factor all these costs into your credit decision.

Conclusion

Many Doorvest customers have recently seen lower rates for HELOCs than other investment property mortgages. Our partner Caltex offers this option. If you are searching for more variety, check out our list of non-traditional ways to finance an investment property. In any scenario, Doorvest's Client Partners are here to help you decide on the purchasing choices that work best for you. You can contact them at clientpartners@doorvest.com, or schedule a call to get your questions answered instantly.