How to Finance a Rental Property with a Second Mortgage
As a would-be property investor trying to buy your first rental property, some of the hurdles you have to scale include saving enough money for the down payment on the property, meeting the stringent loan qualification criteria, and the high cost of private mortgage insurance.
Whatever makes it possible to prevent these obstacles makes your journey to becoming a landlord faster and easier. Did you know you can avoid many of the difficulties associated with rental property loans using a second mortgage as your financing option?
What is a second mortgage?
It is a loan taken out on a property that is already on a mortgage. It adds a second mortgage to the existing mortgage on your home. You can use this option if you have built up substantial equity in your home, up to 20%. With a second mortgage, lenders essentially let you exchange the built-up equity in your home for cash. How does this work?
Home equity and how is it created
Your home equity is the difference between the market value of your home and the amount you owe on the mortgage. The mortgage represents the portion of your home’s value owned by the mortgage provider, while equity represents how much of the house belongs to you. You create equity initially when you make a down payment on your property.
This initial equity depends on how much you paid down. If your down payment was 5%, 10%, or 15%, your equity in the home will also be 5%, 10%, or 15%, respectively. However, the amount of equity you have in your home does not remain static. Over time it grows as a result of your monthly mortgage payments and as the home appreciates.
The equity in your home is your money and is what lenders let you borrow on. You can borrow up to 80% of the appraised value of your home, less the balance on your mortgage. That means if your home has a current value of $500,000 and the balance on the mortgage is $ $325,000, the bank will let you borrow as much as $75,000.
Financing a rental property with a second mortgage
Many homeowners use money from a second mortgage to pay off high-interest consumer loans or finance home improvements. While these are perfectly legit ways to use the money, the absolute best way to use money from a second mortgage is a down payment on a rental property. There are several reasons why this is the perfect way to use a second mortgage
1. Avoid saving for a down payment
The down payment requirement is one of the most stringent conditions to meet before getting a rental property loan. Saving that money takes time, especially when you have the monthly payments on your home mortgage. However, with a second mortgage, you can use the asset you already own to acquire more assets. Furthermore, the interest on that loan is tax-deductible.
2. You can avoid PMI
If your down payment on a rental property is less than 20%, you will be required to buy Private Mortgage Insurance (PMI) - better known as Canadian Mortgage and Housing Corporation (CMHC) fees. Even with a 20% down payment, this may still be a requirement. These payments can be as high as 4% of the value of the property. But, with a second mortgage, you can avoid PMI altogether.
3. Lower interest rates
A second mortgage attracts a lower interest rate because the property secures it. Your primary home serves as the collateral for the loan, and the lenders know they can take possession of your home in case of default. Consequently, the loan is more secure, and the lender is willing to accept a lower interest rate. Although this rate will be higher than the interest rate on your first mortgage, it will be lower than the interest on a conventional rental property loan.
The two types of home equity loan for property investors
There are two types of home equity loans to buy investment properties:
I. Fixed-rate Home Equity Loans
Fixed-rate home equity provides a lump-sum payment with a fixed interest rate and is repayable over a set period. The loan usually runs for 5-15 years, and the monthly payment plus interest rate stays the same throughout the period. This type of home equity loan is appropriate for property investors who use a buy-and-hold strategy; they plan to rent the home to tenants.
II. Home Equity Line of Credit (HELOC)
This type of home equity loan puts a specific amount of money at the disposal of the borrower. They can borrow from it and repay it repeatedly throughout the loan. The interest rate will vary according to market rates. The monthly loan payments depend on how much they drew from the account. This type of home equity loan is suitable for investors who flip houses.