First of all, the answer to the question “Can you take equity out of a rental property?” is “Yes.” For some people, it’s the best way to get access to cash when they need it. For other people, there are better ways to build some liquidity. Let’s take a look at the ins and outs of this decision and go over some scenarios in which it makes sense – and some others in which it might not.
How to take equity out of Rental Property
There are two major ways to take equity out of rental property: a home equity loan, or a home equity line of credit (HELOC). Both of these use the investment property as collateral, and you pay back what you borrow over time at a pre-set variable or fixed interest rate.
Have you been building up charges on your credit cards as you try to make ends meet?
Then a HELOC to pay off those charges could make sense. Credit card balances often carry a much higher interest rate than a HELOC would. So you’re smart to save money.
What if you’re not in a bind financially, but you want to make some major improvements?
If you don’t have the cash on hand, taking out a home equity loan (2nd / 3RD Mortgage) or HELOC to cover those expenses, and then to pay the loan back, can be less expensive than charging the cost of the renovations and then paying back those balances off your card.
It’s probably not smart to take out a home equity loan or HELOC because you’ve hit age 50 and want to buy that Corvette or other flashy sports car. Home equity is an investment that you have worked hard to build up over time. If you’re fairly close to paying off the mortgage on that rental property, then you’re about to have an infusion into your regular budget – which you could use to save toward that purchase.
A lot of our customers ask us just what “equity” means. Imagine your house as a giant aquarium. As you pay off your mortgage, imagine that aquarium filling up with water. When the aquarium is full to the top, then the house is paid off, and it’s all yours. The “equity” is the amount of water – the amount of the home’s value that you own.
Let’s say that you bought that condo for $500,000. You had initially put $125,000 down, and you now have a balance of $25,000 remaining on the mortgage. However, if you conducted an appraisal on the condo today, and it came back at $800,000, then you have built up $775,000 in equity on the property, more than 50% above the condo’s original value. Another way to look at equity is the amount of money that you would receive (less applicable fees and other transaction costs) if you sold the house today.
So if you have all that money sitting in equity, and you’ve come to a point where you need to use it, then taking out a loan or line of credit on that equity can make a lot of sense. Maybe you have a youngster heading to college. Maybe you have a chance to invest in another condo on the same block, but you don’t have enough to cover a down payment large enough to give you a prime interest rate. These are all good reasons to take out some of your home’s equity and start paying yourself back. If you live in a major urban market, you can take as much as 75% of your equity out in a loan (combined with your existing mortgage), while that usually tops out around 65% in rural markets.
Here’s one word of warning. If you do take out a home equity loan, or if you do use some of your home equity line of credit, that loan has the same force as your original mortgage. So if you fall into default on this loan, the lender can foreclose, just like your original mortgage lender can. So make sure you have it in your budget to make those payments on top of your regular expenses. You don’t want to get into a bind six months or a year down the road.
How to Take Equity out of Your House to Buy Another
There are some parts of Canada where the prices of real estate have already shot up toward what is likely to be a peak for the time being. In some other areas, though, the markets are just heating up, and interest rates are still at rock-bottom levels. This makes this a terrific time to start investing in real estate. However, if your liquidity is on the low side, where do you get the funds?
You can take out a mortgage, or you can sell some of your other investment assets, such as bonds or stocks, or you can raid your IRA, or you can take out equity to buy a second home.
What is home equity?
It’s the difference between the market value of your home, as determined by an appraisal, and what you owe on the mortgage. If you bought a house for $750,000, and you’ve paid down the balance on the mortgage to $250,000, but the value of the home has gone up to $900,000 in the years since you bought it, you have $650,000 in equity on the house. You can take out a home equity loan, home equity line of credit (HELOC) or cash-out refinance in order to get the money out so that you can buy another house, provided you meet prime lender credit and affordability requirements.
Take out Equity to buy Second Home
If you want to take equity out of your house to buy another, there are some real benefits. You’re likely to get a better interest rate and lending term from the bank, because you have more at stake – two properties with collateral. If you take out a second mortgage to buy that second home, you represent a higher risk than someone who refinanced their primary residence to make that purchase. If you run into financial difficulties, you’re more likely to let a second home go into foreclosure if that loan doesn’t jeopardize the place where you live. You can save on this loan, because you won’t have to pay fees for title searches or many of the other costs that go with taking out a new mortgage, because you’re accessing the equity in a home you already own instead of asking for financing to purchase a separate one.
There are some drawbacks to this too, of course. You will now face a higher mortgage payment each month when you take equity out of your house to buy another property. If you plan to rent out the second property, that income can counteract the higher payment. However, if you run into financial trouble and can’t make the payments, your primary residence is the collateral – and it is what the bank will come after if you go into default.
If you are planning on investing in a second home to “flip” it – or make some improvements and then sell it at a profit, then you won’t have that larger mortgage payment for long, because you can take the profits and use it to pay down that larger mortgage or save some of the money and then reinvest the profits elsewhere.
If you are planning for this second home to be a vacation home, you could consider renting it out on the weeks when you don’t plan to use it. That secondary income can help you with that larger mortgage that you have now as well. There are many property management companies that can help you administer a rental property either in your own city or in a place on the other side of Canada.
Planning to use it as a rental property with a full-time tenant?
You’ll still have money rolling in once the lease gets signed, which should help you with those mortgage payments. Once again, though, you don’t want to take on a mortgage payment that you can’t handle – even if you have zero income coming from the rental property. Don’t let your primary residence end up be the one facing foreclosure because you gambled the place where you and your family live – and you lost.
If you have other questions about your home’s or investment property equity, contact Amansad Financial today. Your personal situation can be reviewed so that a recommendation can be made as the best course of action.