Can Equity Be Used as a Down Payment for an Investment Property?
You can take out a purchase mortgage to buy an investment property, but lenders often require you to make a down payment of at least 20 percent. Aside from this expense, you also have to pay the closing costs ,which means that you need over $20,000 in cash if you want to buy a $100,000 investment home. In the absence of cash, you can tap the equity you have in your existing home. Tapping your equity to make a down payment could save you money in the short term, but it could also lead to issues in the future.
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Cash Out
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If you do not have a mortgage on your existing home, you can extract equity with a cash-out refinance loan. You can extract up to 80 percent of your equity with a cash-out mortgage and you can use the money to cover your investment home down payment. Lenders charge lower interest rates when you finance a primary residence as opposed to an investment home. To take advantage of these savings you could extract enough equity to cover the entire cost of the purchase so you can avoid taking out a loan on the actual investment property. If you already have a mortgage on your primary home, you can take out a second lien loan such as a home equity loan. Typically, the first and second liens combined cannot exceed 80 percent of the value of your primary home.
Convenience
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When you extract equity in the form of a home equity line, your lender sets up a credit facility that you can draw on at any time. You only have to pay interest on the line of credit if you carry a balance on the line. This means you can set up your credit line before you are ready to buy an investment property so that you have instant access to cash for a down payment whenever you find a property to buy. Some people use one equity line to cover costs related to multiple purchases of investment homes because you can pay down the line and draw on it again in the future.
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Taxes
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Interest payments on mortgages secured by a primary home are generally tax-deductible. Furthermore, you can deduct interest payments on up to $100,000 on home equity debt if you secure that debt against your primary home. Interest payments on credit cards, vehicle loans and other types of debt are not tax-deductible. Therefore, a cash-out mortgage or home equity line may represent the most cost-effective way to cover your down payment. However, some people in the highest tax brackets have to pay the federal alternative minimum tax (AMT) rather than income tax. If you are impacted by AMT, you cannot deduct equity line interest payments, so consult a tax professional before you take out one of these loans.
Considerations
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When you take out an equity line of credit, you have to pay a variable rate of interest. These lines are attached to indexes such as the London Interbank Offered Rate or the United States prime rate. The rate changes every time the index goes up or down. When the interest rate goes up, your payment goes up, and, in a worst case scenario, you may find that you cannot afford to pay the loan. If you do not pay the loan, you stand to lose your primary residence to foreclosure rather than the investment property.
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