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American homeowners have seen a drastic increase in their home equity over the last couple of years. In the first quarter of 2022, homeowners saw their equity grow by 32.2% from the previous year, according to CoreLogic, with an average increase of nearly $64,000 per borrower.
Having a lot of equity can give you leverage to work toward other financial goals, and one of those could be investing in a new property. It's important to keep in mind, however, that there are both benefits and drawbacks to owning multiple properties, particularly if there's a downturn in the housing market.
Here's what you should consider before you decide to use your home equity to buy an investment property.
Using Home Equity to Buy an Investment Property
If you have equity in your home, you may be able to tap some or even all of it with a home equity loan, which offers a lump-sum payment, a fixed interest rate and a fixed repayment term.
To obtain a home equity loan, a common requirement is a credit score of 620 or above, though each lender has its own criteria for determining eligibility. If you want to qualify for a low interest rate, a higher credit score is better.
Many lenders only allow you to borrow up to an 80% combined loan-to-value ratio (CLTV), which means that both your primary mortgage loan and your home equity loan can't exceed 80% of your home's value.
However, certain lenders offer higher CLTV limits, some of which can be as much as 100%. Regardless of the limit, you'll need to assess how much equity you have to determine if it's enough to achieve your goal—you'll typically need to put down at least 15% on the investment property to get approved for a mortgage loan.
For the remainder of the purchase price, you can use a traditional mortgage loan. You'll typically need a credit score of 680 or higher, depending on the lender, and you can generally expect to pay a higher interest rate than for your primary mortgage.
Pros and Cons of Buying an Investment Property With Home Equity
There are both advantages and disadvantages to using the equity in your primary residence to help fund the purchase of an investment property. Here's what to consider before you get started.
- You can get help with the down payment. If you don't have enough cash to put down 15% on an investment property, a home equity loan can help you reach that goal. What's more, putting down more than 15% could help you secure better financing terms.
- You may get a lower interest rate. Depending on the situation, you may be able to secure a low interest rate on your home equity loan, which is a better option than hard money loans or other loans that some real estate investors use.
- Leverage your assets to build wealth: On its own, your home equity isn't doing much to help you build wealth. But if you can leverage it to buy another property, you can improve your financial situation over the long run with an extra income source and appreciation on the new property.
- You're trading an asset for debt. Left alone, home equity is an asset, albeit an illiquid one. While a home equity loan allows you to tap into your equity, you'll need to pay interest and fees for that privilege.
- You may be more vulnerable to shifts in the housing market. The housing market can fluctuate over time, which can have a big impact on homeowners. If you own multiple properties, though, those impacts can compound and make things worse for you. If you can't keep up with your payments, you could lose one or even both homes.
- A high CLTV could come back to bite you. If you choose a lender that offers a higher CLTV because you need the extra money, you could end up underwater on your loan if the home loses some value.
Alternatives to Using Home Equity to Buy an Investment Property
If owning real estate as an investment is an important part of your financial plan, it's essential to consider all of your options when it comes to a down payment and financing for the purchase.
Here are some potential alternatives that can help you accomplish your goal without dealing with the drawbacks of using a home equity loan:
- Cash savings: If you have enough money in savings to make a down payment, you can avoid dealing with an extra loan.
- Hard money loan: These short-term loans are offered by individuals and private companies. You'll typically only have a few years or less to repay these loans, and they carry higher interest rates, so they're generally best for house flippers and for people who can't qualify for a traditional mortgage loan right now but plan to reapply at a later date.
- Peer-to-peer loan: Peer-to-peer lending platforms can help connect individual investors with borrowers to help you finance the purchase of an investment property. However, these loans also tend to charge higher interest rates than traditional mortgage loans.
- Personal loan: If you have great credit, you may be able to qualify for a personal loan with a relatively low interest rate. What's more, these loans aren't secured by the home, so you don't have to worry about the possibility of foreclosure. However, loan limits can be low with some lenders, and repayment terms typically range from just one to seven years.
You may also consider opportunities to invest in real estate indirectly until you're fully ready to buy a property on your own. Real estate investment trusts (REITs) are one option that can make it easier for you to invest in real estate without a major investment.
Review Your Credit Before Applying for a Home Equity Loan
If you're thinking about tapping your home equity to buy an investment property, it's important to review your credit score and credit report to ensure that you're ready to apply. Even if you meet the minimum requirements, it may still be a good idea to take some time to improve your credit before you submit an application to maximize your chances of qualifying for a low interest rate.