In my earlier years as an investor, I kept hearing about the power of a HELOC. But, it wasn’t super clear what it was for, or why it was a great tool for a real estate investor. Today, I have a special guest post from my friend, Levi, to explain this exact concept. Fast forward to the present day and it’s a strategy that I’m looking to deploy within the next few months in order to make some big moves. This article will help you to understand the concept…
Your money is lazy.
Like a person who wants to be in shape but who has a love affair with chocolate, your money struggles to be all that it can be. And without the right investment, your money never live up to its potential.
But if you own your own home and you’re ready to put your money to work, letting it earn more for you than you ever dreamed it could, then the time is just right to consider a Home Equity Line of Credit (HELOC).
What is a HELOC?
In order to understand what a HELOC is, you first have to understand what the term means. So let’s break it down.
Home equity (HE) is the value that your home accrues as you begin to pay down your mortgage while the market value of your home is simultaneously increasing.
A line of credit (LOC) is an amount of money that a bank or lending institution has agreed to lend you. Once you’re approved, the bank holds the money for you and you withdraw it as you need it, similar to how you use your credit card.
So for a practical example of this, let’s say you purchased your home a few years ago for $200,000. You’ve been making your mortgage payments faithfully over those years and now you only owe $145,000.
In the time that you’ve been making those payments, the value of your home has been increasing too. It’s now worth $215,000. The amount of home equity you have is the current market value of your home ($215,000) minus your remaining mortgage ($145,000). So in our example, your home equity would be $70,000.
Has my home value really increased in the time that I’ve owned it?
The short answer is yes, it very likely has.
According to Zillow, the median home value in the U.S. has risen 7.6% in 2018 alone. If you’ve owned your home for several years, the value has been steadily increasing during that time.
It’s also worth noting that this increase is just the market value of your home, and assumes that you have made no improvements during the time that you have owned it. If you have done some renovations and made some improvements, then the value of
your home could be worth even more than the standard median increase would indicate.
But to get you started and give you just a basic idea of your equity, try one of these tools to show you the current market value of your home. Then you can use that figure to determine your own home equity.
If you own your own home, have no plans to sell it, and are just living in it, your current ROI (return on investment) is $0. You are not making your money, the equity you have built up in your home, work for you. But a HELOC would give you additional funds that would help you invest in property that would make money for you.
How does a HELOC work?
As I mentioned, a HELOC works somewhat like a credit card. Like all credit cards you have to pay the money back, and you have to pay it back with interest.
When you are approved for a HELOC, you have a predetermined amount of money at your disposal. That amount depends largely on the equity in your home.
Once your application for the HELOC is approved and you have it set up, the money is there for you to use as you need it. You also pay it back as you are able.
For instance, let’s go back to our initial example where you have $70,000 equity in your home. Let’s say you were approved for a HELOC of $50,000 and you immediately use $10,000 of it to fix something in your home. After that, you stop taking money from the HELOC because you met your immediate need. Now instead of borrowing more from it, you work to pay back some of that money you already used, eventually paying back $5,000 on the principal. You would now have $45,000 of HELOC funds available to use.
However, you have to keep in mind that you’ll need to pay interest. The interest rate for the HELOC can fluctuate and vary during the entire time you have the HELOC. Keep an eye on the interest rates to know what you own at any given time, but also know that that interest rate from a HELOC is lower even than a credit card.
Also know that you only pay interest on the amount that you borrow, not the entire HELOC amount. So in our example, that means you’re only paying interest on the $10,000 you used, not on the whole $70,000.
There are 2 important “period” of you should be aware when it comes to HELOC:
- A “draw period,” which is the amount of time that you’re allowed to withdraw the money. During that draw period, you can take money out and repay it as often as you want.
- At the end of the draw period, there’s a “repayment period,” which is a set number of years in which you must repay the HELOC in full.
It’s important to pay careful attention to the terms of your HELOC so you know how yours must be repaid.
Why should you get a HELOC?
There are several advantages to getting a HELOC over other borrowing options.
- It’s relatively low risk. The interest rate is lower than a credit card and you know the terms of the agreement going in, which makes it lower risk than other borrowing options.
- The pros outweigh the cons. See the list below for more details.
- You are borrowing from what you already have. Standard loans have you borrow money that is not yours. A HELOC lets you put money that is already yours to put to good use instead of just borrowing additional funds.
What makes a HELOC successful?
The key is using the HELOC for the right reasons.
Let’s start with the wrong reasons to get a HELOC. They include taking a dream vacation, paying off credit card debt, or paying off school loans. While those are all admirable financial goals, they don’t help you make more money, which is the goal in accessing your home equity.
Remember that the HELOC is in essence a loan that has to be paid back. It is not free money. So in the case of the vacation, you’re creating more debt for yourself that has to be paid back. In the case of paying off existing debt, you’re getting rid of debt in one place, only to add it in another.
So what are the right reasons for getting a HELOC? The wisest reason to get a HELOC is so that you have money to use as a down payment on Positive Cash Flow real estate investment. Why? So that you are creating a passive income stream and adding to your wealth. You are making your money work for you.
This path requires a little extra due diligence as you consider what property to purchase. Once you have access to the HELOC funds, follow these steps.
- Run the numbers. Know how much money you need to bring in each month in order to cover both the mortgage on your new property and make payments toward the HELOC.
- Choose a property that will meet your financial goals. If the monthly mortgage payments on a potential investment property are already high enough that they won’t allow for charging more to cover your HELOC, then that is not the right property for you.
- Give yourself time. There are a lot of properties on the market. Take your time to find the one that works for you. Beyond the mortgage payments, also take into consideration the age of the home, whether or not it needs any renovations to get it ready to rent, and if it’s in a desirable location that will make it easy for you to find tenants.
What are the pros and cons to getting a HELOC?
Here’s how the pros and cons of a HELOC stack up against each other.
- You have access to the money for the entire length of the draw period, and can borrow and pay back that amount (or any part of it) during the pre-established period.
- Even though the interest rate can fluctuate, some lenders might let you convert that variable rate to a fixed rate. This usually only happens when you’re done borrowing the money. Talk to your chosen lender for more details.
- As I mentioned, even with a variable interest rate, that rate is likely still lower than other borrowing options, like your credit card.
- The interest might be tax-deductible. I recommend talking with an accountant prior to getting a HELOC so that a professional can help you understand the loopholes and benefits available to you.
- You’re opening this HELOC against your primary residence. That means that not repaying it in a timely manner could mean penalties like losing your home. It’s best to treat the HELOC with the same level of importance that you would a second mortgage.
- A HELOC is dependent upon the value of your home. If for some reason that value significantly declines during the draw period (like another real estate market crash occurs), then it’s possible your HELOC could be frozen even in the draw period. Basing a loan on the economy always comes with a risk.
- The prime interest rate informs the variable interest rate. If the market is not great and the prime interest rate goes up, your variable rate could too.
Once I have the HELOC and have purchased an investment property, now what?
Assuming you have tenants and are meeting your financial goals, your first step is to repay the HELOC. Once you do, the money that you’re bringing in from the investment property is all yours, minus the mortgage payment. You have successfully created a passive income flow and your money is now working for you!
At that point, the challenge becomes repeating the whole process. Start the work on securing a HELOC on your investment property. With that second HELOC, you can follow the same steps as with the first: find another great investment property, pay back the HELOC with the funds coming in that are above and beyond the mortgage payment, and then keep the profits after the HELOC is repaid.
What do I need to qualify for a HELOC?
Every lender is different so you’ll want to explore several different options before making your choice, however most lenders check for the following:
- You already have enough equity built up in your home to borrow against.
- Your credit score is good. (A worse credit score won’t always mean you’re denied a HELOC, but it likely means that your interest rate will be higher.)
- You have a solid income and no major debts that you are already repaying.
How a HELOC worked for me
I have personally followed the formula laid out here twice, and obtained two different HELOCs that I have used to purchase investment properties and establish a solid passive income stream.
My first HELOC was for $100,000. I bought my first rental property with that money. Before I secured the second HELOC, the lender I used required that the first HELOC be closed. I achieved this by refinancing my mortgage from the home I live in and my HELOC into one loan, which I paid on for two years. At that point, I got the second HELOC and used that money to make my down payment on a second rental property.
Pre-HELOC status: I had a home that I was living in that had no current ROI.
Post-HELOC status: I own two rental properties that give a solid return on my investment in them. I have a steady passive income stream.
I SHIFTED the equity from my primary residence to Investment Property.
My formerly lazy money is now working hard for me. It’s giving me additional income to meet the personal goals I have, one of which is working less so that I can spend more time with my family. And you can’t put a price on how valuable that is.
Now’s your time. Take that money out of your home and make it work for you!
One of my goals for the next couple of months is to secure a sizable HELOC. That will give me leverage as a cash buyer, and then I can simply refi soon after the transaction closes (if I so choose).
So, what do you think, readers? Have you considered this tool ever for real estate investment purposes?
*Levi is W2 employee (for now) in the hunt for #PassiveIncome! He blogs at where he is covering his journey to create a Boost in his income through, A) Passive Income Online (Affiliate Marketing, Email Marketing) & B) Passive Income Offline (Real Estate Investing for positive cash flow).