Using a HELOC for Down Payment on an Investment Property

Investment Property Requirements

To purchase an investment property, you need a 20% downpayment and approximately 2% of the purchase price for closing costs.

Mortgage Qualifying Basics

Assuming you have good credit, qualifying for a mortgage in Canada is determined by your debt servicing qualifying ratios calculation. In other words, the percentage of your household income that must go towards housing expenses and debts.

The variables that go into this calculation are:

• Mortgage Payment
• Property Taxes
• Heat Expense (Generally, $100 per month is used)
• 50% of Condo Fees (if applicable)
• Debt payments
• Gross income, or 2-year average of gross income in many cases
  

When calculating your qualifying ratios to determine how much of a mortgage you can qualify for, here is how lenders consider mortgage payments, debt payments, and HELOC payments:

Mortgage Payments: The mortgage payment used in the qualifying calculation is based on what your mortgage payment would be if your rate were 2% higher than the actual rate you will receive. This is called the qualifying rate or the "stress test" rate. For existing mortgages, the actual payment amount is used.

Debt Payments: For loans with set monthly payments, the actual payment amount is used. For revolving credit (credit cards or personal lines of credit), 3% of the balance is used.

HELOC payments: Instead of using 3% of the balance, the payment attributed to a HELOC is based on the HELOC's limit, amortized over 25 years, using the current qualifying "stress test" rate.

At the time of writing this, there is at least one lender that will attribute a payment to the HELOC based on the balance (including the drawdown for downpayment and closing costs rather than the HELOC limit).

HELOC for Down payment

Using a HELOC for a down payment on an investment property purchase is not ideal because of how payments are attributed to the HELOC when calculating the qualifying ratios (see above).

This means using a HELOC for a down payment on an investment property limits the amount of mortgage you can qualify for.

The Better Way of Accessing Equity to Maximize the Mortgage You Can Qualify For

To maximize the mortgage amount you can qualify for when purchasing an investment property with down payment coming from your principal residence home equity, it is better to refinance your existing mortgage to access the equity in your home rather than using a HELOC.

Your new mortgage can be amortized over 30 years to make your payments as low as possible.

This way, the debt servicing calculation will use the actual payment amount rather than a payment based on the HELOC limit, amortized over only 25 years, and using the qualifying rate.

It makes a huge difference.

The Major Downside of Refinancing to Access Equity

When you refinance, you are breaking your existing mortgage and replacing it with a new mortgage for a higher amount.

Breaking the mortgage will likely require you to pay a pre-payment penalty which can be very costly depending on the terms of your existing mortgage.

Using Rental Income in the Qualifying Calculation

The investment property's rental income can be used in your application to improve your qualifying ratios; however, most lenders will only use 50% of the rental income. Some lenders will use 100% of the rental income, but the interest rate with these lenders is a little higher.

Even if 100% of the rental income is used, Canadian real estate is so expensive that finding a property that earns enough rental income to cover the cost of the mortgage payment and property taxes is nearly impossible.

This means for most Canadians above average income and/or plenty of equity will be required to purchase an investment property using home equity for the down payment and closing costs.

Long-Term Investment Alternative to Real Estate

If you're thinking of purchasing an investment property right now, it's likely your real goal is to make an intelligent long-term investment to move you closer to financial independence.

While historically, real estate investing has made many people wealthy, there may be a better and safer way to reach your goals.

For example, this chart shows the different asset classes available to invest in and their annualized returns over the past 20 years.

This chart was originally intended to show the power of buying and holding stock investments long term compared to the approach of the average investor who buys and sells based on emotions.

If you want to learn more about investing in stocks using index funds we suggest reading The Little Book of Common Sense Investing by John C. Bogle.

Historically, Real Estate Investment Trusts (REITs) have also been shown to be good investments. A REIT invests directly in real estate by purchasing properties or buying up mortgages. A REIT's shares are traded on a stock exchange and can be bought and sold like any ordinary stock. For a company to qualify as a REIT, it must invest at least 75% of its assets in real estate and generate at least 75% of its revenue from real estate.

REIT index funds exist and can be used as an even more diversified way to invest in real estate.

This information is not intended to be investment advice.

Borrowing to invest – When is interest tax-deductible?

It is important to seek professional advice from a qualified tax advisor and to consider all potential risks and benefits. This information is not intended to provide legal or tax advice.

Borrowing from equity at low-interest rates to invest and earn higher interest rates can be a great strategy to use on the path to financial independence.

However, it is important to note that borrowing money to finance the purchase of securities involves greater risk than purchasing with cash alone. Even if the value of the securities purchased decreases when you borrow money to purchase them, you still have to repay the loan as required by its terms.

Using borrowed money to invest in securities like shares of stock or REIT units can also offer tax benefits by allowing you to deduct the interest expense on your taxes.

Conclusion

The rental income of the property you're purchasing can be used towards the application to improve your qualifying ratios, but the beneficial impact it has is less than you would hope it would be.

Because of how lenders treat HELOC payments when calculating qualifying ratios, using a HELOC for the down payment on your investment property is only a good option if you have a very high household income and ample room in your qualifying ratios.

Refinancing your mortgage to a new larger amount, amortized over 30 years, may be a better way of accessing equity if your goal is to obtain the maximum mortgage for purchasing an investment property.

For most Canadians, buying an investment property with down payment from home equity is only possible with above-average household income and a large amount of equity available. Particularly because of the high price of homes in Ontario and the high qualifying "stress test" rates that must be used when qualifying.

Borrowing to invest in publicly traded stocks or REITs can still be a good route to advancing on the path to financial independence as long as you approach it with a proven long-term strategy.

Interest expenses can be tax deductible when borrowing to invest, and topping up RRSPs can also provide you with a large tax savings.

We suggest reading The Little Book of Common Sense Investing by John C. Bogle to learn more about an alternative way of investing intelligently for long-term wealth creation and reaching financial independence.