4 Reasons You Shouldn’t Use Home Equity To Invest in Real Estate, According to Financial Experts
By investing in real estate, such as buying rental properties or renovating a house to flip, you can earn passive income and diversify your investment portfolio. But unless you have the cash on hand to buy an investment property, you’ll need to find a way to finance the purchase.
Explore More: 7 Reasons You Must Speak To a Financial Advisor To Boost Your Savings in 2024
Try This: Become a Real Estate Investor for Just $1K Using This Bezos-Backed Startup
Using your home equity may be a tempting option, but it’s important to understand the risks and downsides to using equity to invest in real estate.
How Using Home Equity Works
You can potentially use your home equity, or the portion of your home that you’ve paid off, through a home equity loan or a home equity line of credit (HELOC). Jason Smartt, head of consumer banking at The Federal Savings Bank, explained that both products are considered second mortgages, meaning that the loan is in the second position or is the second priority after your primary mortgage.
Smartt explained that there are a few key differences between the two products:
A HELOC features an open line of credit for a set amount of time after your loan is funded. During that period — called the draw period — payments are usually “interest only.” After the draw period, the loan becomes an amortizing loan, meaning you’ll be making principal and interest payments. Many HELOCs feature adjustable interest rates, meaning the interest rate could increase in the future if the market rates change.
A home equity loan is a standard loan made against your home’s equity, where you’ll make principal and interest payments. Interest rates on home equity loans are fixed.
There are some benefits to HELOCs and home equity loans. If your primary mortgage interest rate is lower than the current market rate, tapping into your home’s equity via a loan or HELOC can help you to avoid increasing your primary mortgage interest rate, said Smartt.
HELOC and home equity loans can also typically be for a smaller amount than a primary mortgage, but for a larger amount than a personal loan or credit line. “Our typical HELOC or home equity loan is around $100,000, versus our typical personal loan is $25,000 and our average mortgage is $400,000,” explained Smartt.
Check Out: Barbara Corcoran’s 5 Best Passive Income Ideas
Using Home Equity Puts Your Home on the Line
Using your HELOC or home equity loan to finance a real estate investment means that you’ll be putting your primary residence on the line if you’re unable to repay that loan. “If the investment property turns out to not meet the cash flow needs of the loans, then the borrower is putting their primary residence at risk,” Smartt said. “Borrowers should mitigate the risk by ensuring they can afford both mortgages, even without the investment property cash flow, to be conservative and prudent.”
Matthew Hanna, home equity sales director at First Tech Federal Credit Union, explained that a HELOC may be helpful for not only acquiring property, but also for any future maintenance needs. “A HELOC is a great product when someone is using the funds on a project that’s going to take multiple months or years to complete, like doing an entire home remodel over the course of a couple of years, or if you’ll need access to the funds periodically,” he said. “However, buyers must be mindful of having a plan to repay the debt.”
Home Equity Interest Rates Are High
Smartt explained that while home equity loans and HELOCs typically have better interest rates than personal loans or credit cards, their rates are still higher than a typical mortgage interest rate. Buyers will need to consider the size of the loan or HELOC and the overall interest that they would pay across the life of the loan.
It Can Be Difficult To Qualify for a HELOC or Loan
Smartt cautioned that buyers also need to be aware of some common limitations of HELOCs and home equity loans. According to smart, both HELOCs and home equity loans have a maximum loan amount that is much lower than a primary mortgage. These options may help finance a smaller real estate purchase, but might not be practical if you need to come up with a large sum of money.
Additionally, Smartt explained that it can be more difficult to qualify for a HELOC or home equity loan than it is to qualify for a typical mortgage. For example, your lender might require you to have a lower debt-to-income ratio threshold and might require a lower loan-to-value threshold than you would face if you applied for a traditional mortgage.
Interest Rates and Home Values Can Change
Hanna explained that since HELOCs have adjustable interest rates, buyers need to be aware of the potential for those rates to increase if the Federal Reserve decides to make changes impacting interest rates.
Additionally, market changes that affect your home’s value could impact your mortgage and your home equity. “If the individual is leveraging a primary residence and the value of the subject property declines, their mortgage and home equity balances could be higher than the home’s value,” said Hanna.
Alternative Ways To Finance an Investment Property
When it comes to using home equity to invest in real estate, Smartt highlighted the importance of buyers making sure that they’re financially secure and that they’ll be able to make their payments. Otherwise, other financing options may be a better choice. He explained that buyers might use their own cash, a commercial loan or even an SBA loan as an alternative to relying on their home’s equity.
Hanna encouraged anyone considering buying an investment property to speak with a loan officer about the requirements of purchasing such a property, including the estimated monthly payment, required down payment, estimated closing costs and required cash reserves or additional assets. He also encouraged buyers to consult with a property manager to discuss expenses that could come with using the investment property as a rental. Additionally, he said that buyers should connect with a tax advisor to see how the purchase could impact their tax returns, and then work with a real estate agent to find a property that meets their requirements.
“Education is the key to understanding home equity loans and HELOCS,” said Hanna. “Individuals need to take the time to connect with a loan officer to see what options are available to assist them with their goals — whether that’s improving their existing property, purchasing their first home or buying an investment property.”
More From GOBankingRates
This article originally appeared on GOBankingRates.com: 4 Reasons You Shouldn’t Use Home Equity To Invest in Real Estate, According to Financial Experts
