When investing in real estate there are a bunch of different ways to fund your investment. You can use your cash, a partner’s cash, a hard money lender’s cash, but you can also tap into the equity in your home to fund your portion of the down payment for an investment property.
What is a HELOC?
HELOC stands for Home Equity Line of Credit. A line of credit just like a credit card where you can borrow from it and pay it back and then borrow from it again. However, HELOCs typically have much higher borrowing amounts and much lower interest rates than credit cards because they are using your home as collateral for the loan.
What this means is that instead of just sending you to collections like a credit card company would if you stopped making your payments with a HELOC if you stop making your payments they will foreclose on your home.
HELOCs typically are divided into two time periods: a draw period and a payback period. The draw period can vary, but 10 years is pretty standard. During this time you can draw money from your line of credit and your monthly payments are interest only payments. This is nice because it means you have more time to pay back the principle while your required monthly payments are smaller.
Your payback period also varies, but 5-10 years is the typical range. During this time you can no longer draw money from the HELOC and your monthly payments increase to include the principle as well as the interest.
When Does Using a HELOC Make Sense?
Obviously, a HELOC isn’t for everyone. For starters you not only need to own a property, but you need to have a decent amount of equity in that property for a HELOC to even be an option.
How much equity do you need? Well a bank will typically lend somewhere between 70%-80% LTV. What that means is that your original loan PLUS the HELOC amount can add up to no MORE than 70%-80% of the appraised value of the home.
Example: If your home appraises for $100,000 and you have a loan on the home for $50,000 and the bank is willing to give you a HELOC for 80% LTV that means your max HELOC amount would be $30,000. That means that you can borrow up to $30,000 through your HELOC and use that money for a down payment on an investment property.
A HELOC really makes sense if you don’t have a lot of cash sitting around, but you have a lot of unused equity in your primary residence or in another property and you want to put that money to work by purchasing a rental property.
What are the Benefits of a HELOC?
The biggest benefit of a HELOC is that it allows you to turn the equity in your home into a performing asset. A HELOC increases your leverage and thus your amplification. If you want to read more about leverage and how that increases your return check out our article on Why You Should Invest in Real Estate.
The biggest thing you need to keep in mind though is that using a HELOC to buy a property means that you not only will have your original mortgage to pay and the new mortgage, but you will also have to pay off your HELOC. That’s an additional expense that you need to factor into your financial analysis of the property. The income from your new investment MUST cover the mortgage of the new property AND the monthly HELOC payment.
What are the Alternative Options?
Home Equity Loan (HEL)
With a Home Equity Loan you get a single check, with a HELOC you get a continuous line of credit that you can use as many times as you want as long as you continue paying it back.
Another benefit of a HELOC vs a HEL is that when you get a HELOC you don’t make a single payment until you actually spend the money. With a HEL as soon as you get the check you have to start making payments on the loan regardless of if/when you use the money.
Once you get your HEL that’s it, the terms are set, whereas with a HELOC you can typically go back during the life of the line of credit and renegotiate the terms with your lender.
Cash Out Refinance (COR)
A Cash out Refinance is when you refinance your existing loan and get a new loan on your property. Unlike a typical refinance your loan amount will actually increase and you receive the difference in cash.
For example if your home is worth $100,000 and you owe $50,000 on it you might do a cash out refinance and receive a check for $30,000. However, you no longer own $50,000, you now owe $80,000 on your property.
A COR will change your interest rate on your current property (which could be a good or bad thing–right now in Jan 2023 it’s a bad thing, your new interest rate will almost certainly be higher than your old one). This means that your payments on your existing property will increase a LOT because your loan amount AND your interest rate will both be going up.
A COR will also get you a higher interest rate than a normal refinance would so keep that in mind. Because you’re pulling cash out of the property banks see the property as more risky so they will charge more to give you a loan on it.
Similar to a HEL, a COR is a one time check. The nice thing about a COR is that it is your money and you don’t need to pay it back to anyone and because it’s technically a loan it doesn’t count as income and so you don’t have to pay income taxes on the money you receive.
Conclusion
A HELOC can be a great option to get into real estate investing. We think it beats HELs and CORs almost all the time. If you’re interested in learning more about if a HELOC is a good idea in your specific situation, reach out!
