Given that investment property financing can be challenging to find, especially on high-return properties that usually carry risks that scare traditional lenders, looking to creative sources of debt may be your best way to leverage into investment real estate. The equity in your house is relatively inexpensive and easy to tap. Furthermore, the interest is usually tax-deductible.
Loan or Line
You can pull equity out of your house through a traditional home equity loan, also known as a second mortgage, or with a line of credit. Loans typically have lower rates and better terms, but they're inflexible. With a loan, you take out a lump sum of money on a set date and start paying it back. A home equity line of credit gives you a maximum amount you can draw, but lets you decide when and how much you use. This saves you from paying interest on money you aren't using.
Uses of Debt
Borrowing from your home's equity in lieu of taking out a mortgage on your investment property can save you from the inconvenience and potential expense of getting a traditional investment mortgage. A more aggressive strategy is to use your home's equity to provide your down payment money. If you do this and then get a mortgage to pay for the rest of the property, you're effectively buying it with 100 percent leverage. Since you aren't spending your own money to buy it, your returns are pure profit. Then again, since you have more debt, and more debt payments, on the property, you also have less margin for error in the event that something goes wrong.
Schedule A or E
Most home equity loans and lines have interest that is deductible on Schedule A as an itemized deduction. However, these deductions are limited. You can only write off the interest on your first $100,000 in home equity debt, and if you are subject to the Alternative Minimum Tax, you could even lose that deduction. However, if you take out a home equity loan to buy investment property, you could also write off that interest with your other rental property expenses on Schedule E. Schedule E expenses aren’t subject to the same limitations as itemized personal deductions.
The Key Risk
Before taking out home equity debt to buy investment property, consider the risk that you are taking. If something goes wrong with your investment, it could also affect your ownership of your house. More specifically, if a bad investment renders you unable to pay your home equity loan, you could end up with your house in foreclosure. As such, if you're considering tapping into your house, consider devising a contingency plan that will allow you to continue paying on it if something goes wrong.
Buying a Property
Once you have found a property to buy and put your home equity loan or line in place, using it to actually buy a piece of investment property is no different from using any other source of money. When you're ready to close, you simply transfer the money from your line of credit or from the account holding your equity loan proceeds into the closing account. Since your equity loan is tied to your home and not the property, there won't be any extra paperwork to sign at the closing.
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