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Home Equity Loan: Fund the Down Payment on Investment Property

HSH.com

In the wake of the housing bust, rental properties are making a comeback. Savvy investors are snapping up cheap real estate in some distressed areas of the country like Las Vegas and Sacramento. The San Jose Mercury News recently reported that in Las Vegas, buyers are paying 41% less than they did the prior year, with homes going for a median price of $125,000; in Sacramento, investors paid 15% less than they did a year earlier. One Sacramento real estate broker indicated that homes that sold for $170,000 three years ago are now going for $80,000 to $110,000, and that rents are often high enough to cover buyers' mortgages and provide positive cash flow.

Mortgage Lenders Want Bigger Down Payments

Financing real estate has proven risky in the last few years, and financing investment property even more so. If you want to buy an investment property or rental home, plan on putting at least 25% down. Fannie Mae and Freddie Mac's new "risk-adjusted pricing" means buyers of investment properties pay a lot more for their loans than buyers of primary residences. And those adjustments may be prohibitive when you aren't bringing a large down payment to the closing table. For example, if you have a 699 credit score, Fannie Mae adds an extra 2.5% surcharge when you buy a rental condo with 10% down instead of 25% down. On a $200,000 property, that's $5,000 in additional fees.

Mortgage Insurers Don't Like Rentals

The extra fees aren't the real deal-breaker. If you are an absolutely perfect candidate, your investment-property loan might meet Fannie and Freddie's guidelines. Before they fund your loan, however, you'll have to get mortgage insurance. And here's a Catch-22: many mortgage insurers, like the Mortgage Guaranty Insurance Corporation (MGIC), won't insure rental properties anymore.

Home Equity Loans Can Be Used to Buy Rental Property

If you have decent credit and enough equity in your primary home, a home equity loan might be the ticket to snapping up an investment property bargain. Used for a down payment or even the entire purchase, home equity loans can be cheap to obtain -- many mortgage lenders offer home equity loans with no points and no lender fees. In addition, if your investment property is in a distressed real estate market -- like Las Vegas -- but your main home isn't, it could be a lot easier to get a loan against your primary residence than one against a rental property in a soft market.

Home Equity Loan Repayment: Have a Plan B

One danger associated with using a loan against your primary residence to purchase a rental property is that if you can't make the payment, it's your primary home that's on the line. When running the numbers, don't assume that 100% of the rent will be available to repay your second mortgage. In addition to property maintenance, you'll have taxes, a homeowner's insurance policy, and liability insurance. You may also have vacancies -- underwriters typically assume a 25% "vacancy factor" when calculating rental income, and you should too. Make sure that after accounting for all of your expenses (offset to some extent by your tax deductions) you'll be able to comfortably pay the mortgage on your rental property. Finally, have a couple of months worth of mortgage payments set aside in an emergency fund in case your tenants fail to pay their rent.

Shopping for Your Home Equity Loan

When using a home equity loan for purchasing a rental property, a fixed traditional second mortgage may be preferable to a credit line or other loan with a variable rate, since the payments are safely fixed and easy to budget for. Home equity loans come in a range of terms, but usually not longer than 25 years. Finding the mortgage loan with the lowest rate and best terms is easy to do online, and home equity loans typically close quickly. Home equity loans can be a good solution for those who need to move quickly on an investment property purchase.

Gina Pogol has been writing about mortgage and finance since 1994. In addition to a decade in mortgage lending, she has worked as a business credit systems consultant for Experian and as an accountant for Deloitte.

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