Editor: Do you know if you should use a HELOC to grow your real estate investments? Actually, do you even know what a HELOC is? Debt usually isn’t great, but could this actually help you grow your real estate investments and make even more money instead? Peter tells you everything you need to know about how and why you should use a HELOC in today’s Saturday Selection. This post was originally published on Passive Income MD.
Should You Use a HELOC to Invest in More Real Estate?
When it comes to investing and life, most people will tell you that all debt is bad. It makes sense; so many of us have felt the burden and stress that comes along with debt.
However, as I’ve previously discussed, not all debt is created equal. I believe that debt can be used as a tool to create greater wealth. Of course, this is only true when used carefully and wisely.
Think about student loan debt. Sure, we all wish we didn’t have it, but it also helped us get where we’re at. Without taking a loan, would you have been able to fund your medical education? From a financial standpoint, I consider the student loan debt that I accumulated an investment in my future earning potential.
Now don’t get me wrong, I’m a believer that student loan debt has gotten out of control and at its current rate of growth, it isn’t sustainable. So my hope is for reform in some way. But back to “debt as a tool.”
One way that some investors have used debt to their advantage is to make use of a Home Equity Line of Credit (HELOC). It’s a line of credit that can be used to purchase new investments and make debt work for you.
It allows you to use untapped built up equity in your primary home or existing investment properties as collateral against the HELOC, essentially making investments with investments.
As a result, so many people wonder whether it’s a smart decision or not to utilize this resource.
Of course, as with anything related to finances, there are a few things to keep in mind. Let’s look a little deeper at how utilizing a HELOC might make sense.
What is a HELOC?
At its most basic level, a HELOC is simply a line of credit, much like a credit card. To secure this line of credit, you would put up your property as collateral. There is also a time limit on how long you can pull money on this line of credit, known as the draw period. The average term is typically 10 years.
A HELOC uses what’s known as a “maximum draw” to determine exactly how much credit you receive, which is, in turn, determined by your property’s equity. This is basically your “credit limit.”
For example, if you have $200,000 in equity in a certain property, you may find a lender that will give you 70% Loan to Value, which comes out to a line of credit equal to $140,000.
So that lump sum is allocated to you so when you want to draw from it, it can be as simple as transferring it online between accounts. You only pay interest on what the outstanding balance is, again, like a credit card.
The nice thing is that you can use the HELOC for just about anything, from renovations to consolidation. No one is asking you what that cash is being drawn and utilized for. You can even use it to make a down payment on another property.
How is a Home Equity Loan (HEL) different?
A home equity loan (or sometimes referred to as a second mortgage) is different because rather than drawing from a line of credit source when you want, you have to take the full amount of the loan up front. Then you’re paying interest from day 1.
Why use a HELOC?
So why would someone need or want a HELOC in the first place? Well, some people like having access to the equity in their homes and really want access to cash quickly and on demand.
I’ve talked in the past about how I haven’t kept a designated emergency fund for various reasons. Part of the reason is that I have a HELOC in place as a backup to draw from and I would rather have my money working for me as much as possible instead of sitting idly in an account
People have notoriously used HELOCs though to buy cars and upgrade their lifestyle. They’ve used the rise in their home values to fund this spending. Then when the economy and home values came crashing down, many people faced challenges meeting their debt payments. As a result, since their homes were used as collateral, they would get foreclosed on.
So utilizing HELOCs have gotten a bad reputation.
However, again, like any other tool, I think if used wisely, it can help accelerate the building of your investment portfolio.
Here are some ways it can help do just that:
Help With a Down Payment
Let’s say that you already own one or two investment properties. You’d like to add more, but you’re currently limited by the cash you have on hand. You could take out a HELOC on one of them, and use that credit to make a down payment on another property.
If you’re limited by capital, this would allow you to add even more streams of income.
Then you can use cash flow from investments and your day job to pay off that line of credit, and do it over again.
Help purchase a property in cash
Because a HELOC is readily accessible, it’s possible it could help you purchase an investment property quickly and in cash. Then after purchasing the property, you could take out a loan on the property and pay off the HELOC immediately.
In this situation, you were essentially able to purchase the property for no money down.
Invest in a passive real estate deal
A HELOC would allow you to invest in a passive real estate deal when you don’t have the cash readily available.
Personally I’ve done just that. Again, I don’t like to leave large sums of cash sitting in bank accounts, but I was presented with a great investment opportunity in a syndication deal. However, I didn’t quite have the full amount available to meet the minimum.
I knew that because of my day job and other cash flowing investments, I could pull enough from the HELOC to fund the investment and pay the loan down in 2 months. And that’s exactly what I did. The investment I made not only produces more cash flow for me but is also appreciating in value.
These are just some examples of using leverage to increase your portfolio. After all, unused equity is best put to work for you if you can do it responsibly.
It is extremely important to note that as with anything, a HELOC should be used carefully. As you may have heard, leverage is a double-edged sword. It can multiply your returns but can do the same for your losses.
If you are unable to repay the balance on the line of credit for any reason, you risk losing the property you put up as collateral. This could lead to a pretty disastrous result.
It goes without saying, but even still: have a plan and know just what you’re getting into.
Can You Take Out a HELOC on an Investment Property?
This is a common question, because traditionally, HELOCs are often thought of in relation to a primary residence. However, there is absolutely no reason you can’t do the same on a rental property.
The only obstacle is the lender. Not every bank will allow an investment property to be used as the source of equity, mainly because of the perceived volatility that comes with rental properties.
Because of this, finding a lender willing to allow a HELOC on an investment property can be a little tricky. To find one, it’s best to ask around your local community and seek recommendations.
HELOC vs Cash-out Refinance
Another popular way to leverage equity comes in the form of a cash-out refinance.
A HELOC could be thought of as a second mortgage, in that if you have a mortgage already, it remains in place.
A cash-out refinance, on the other hand, pays off the existing mortgage and takes its place as a different mortgage with different terms.
One of the biggest differences between the two, though, is the interest rate. Because it’s a mortgage, cash-out refinance can be done with either fixed or adjustable interest rates.
A HELOC has a variable interest rate, which can fluctuate along with the US Prime Rate.
Finally, with a cash-out refinance, you do have to deal with closing costs, just as with any mortgage. A HELOC rarely has any kind of closing costs. This is great because any money saved is more money to leverage.
If you’re looking to build your portfolio in an accelerated fashion, a HELOC might be a good option for you.
The thing to consider is that it’s additional leverage and debt.
Would I simply use the HELOC as a long term debt option? Not personally.
I use it more as a bridge to move in and out of deals. It provides liquidity for me while keeping as much of my investable capital working. My goal with any HELOC use is to pay it off as soon as I can before investing in another deal.
I behave the same with credit cards. I utilize them, get points, and reap the other benefits, but I pay them off each month.
I also know that with my day job and current investments, I have positive cash flow that allows me to pay off the HELOC without issue. That provides me a level of comfort in utilizing it for short term access to cash.
Of course, a HELOC isn’t the best option for everyone. As I mentioned before, debt is a tool. Though a large line of credit can be great to have on standby, it shouldn’t be used to purchase properties outside your ability to repay and definitely not into depreciating assets. Put simply, use it wisely.