The world of travel has changed quite a bit in the last decade—hotels aren’t always the best choice for many travelers, especially families. Short-term vacation rentals like Airbnb, VRBO, and Vacasa can be a great way for private citizens to get into the hospitality game. But unless you’re interested in renting out your primary residence, purchasing a property that will be attractive to travelers is the first step in the process.
If you already own a home, you already have an excellent tool for financing that property: your home equity. A home equity loan can be a viable method of obtaining a hefty downpayment on your new investment property.
A home equity loan is based on the equity you’ve built in your home. Equity is determined by the current value of your home minus the amount you owe on your mortgage. Since home values depend on various market conditions, such as available stock and developments in the area, your equity can ebb and flow.
A home equity loan uses that equity as collateral for the amount you want to borrow. Typically, you cannot borrow the total amount of the equity available—80% is the standard rule of thumb.1
Home equity loans are considered secured loans since they have physical collateral attached and come with attractive interest rates.
The process of obtaining a home equity loan is similar to that of applying for a first mortgage. The home’s value has to be established through an appraisal, then terms are decided. Home equity loans are paid in a lump sum of cash and have to be repaid over time on a fixed payment schedule.
In addition to the amount you borrow, you’ll also pay interest on the loan as well as closing costs that cover the preparation of the loan, origination fees, and recording fees. Some lenders offer the option of paying points, or prepaid interest, at closing. This can lower your overall repayment amount but will increase your closing costs. You can choose how many points to take, if any, with your lender.
The beauty of home equity loans is their flexibility. Since they are paid in a lump sum and repaid over time, they can be used for any purpose—home renovations, a fancy vacation, or even buying a short-term rental.
Equity is determined by the current value of your home minus the amount you owe on your mortgage.
Once you’ve applied for and been approved for your home equity loan, it’s time to decide how to use the funds. If buying an investment property is the goal, look at the property’s price. See if your loan is enough to cover the entire cost, allowing you to make an all-cash offer. If it’s not, you can still make a good down payment and have a nest egg to cover the setup needed to start your business.
Depending on where you’d like to buy a short-term rental, having cash available can give you significant buying power. If you’re looking at properties out of the country, this can help you avoid the hurdle of finding a local lender. If you’re looking in the United States, an all-cash offer can help you seal the deal in a bidding war since you’ll have secured capital already.
Since you won’t be living in your rental full-time, many lenders want a more significant downpayment —typically 20%-. Mortgage insurance is not available for rental properties, so making that large a downpayment may require funding from a home equity loan.
One thing to remember is that buying the property is just one expense. Funds from a home equity loan could also be used to renovate a property or furnish it if it’s already in good structural shape. Making it attractive and user-friendly is critical to keeping a short-term rental booked. Also keep in mind recurring costs like cleaning services, insurance, and upkeep.
Since many vacation properties may not have a 100% occupancy rate, you may also leave some funds as a cushion for that time. Can you afford to have a bad month?
While a home equity loan has a lot of pros—flexibility and low interest rates chief among them—there are also cons to taking this route for your short-term rental kingdom. While you will have a lump sum of money, unless you buy your new property outright, you will have three monthly payments that could be quite sizable: your mortgage, home equity loan, and your new mortgage on a short-term rental. Make sure that your monthly cash flow can support multiple payments.
One thing to remember is that buying the property is just one expense. Funds from a home equity loan could also be used to renovate a property or furnish it if it’s already in good structural shape.
Home equity loans are a flexible and relatively affordable way to access a large sum of cash at one time, which makes them ideal for purchasing or making a down payment on a short-term rental. Just be aware of how much debt you are taking on. If you expect to be able to repay your home equity loan using profits from your rental, you may have to contend with vacancies and volatile profits. Have a plan in place if your rental isn’t immediately successful.
This article was originally published by Rachel Murphy in www.investopedia.com