By Elenis Camargo
Let’s assume you saved up money for over a year, acquired a rental property, and now you’re back at zero savings in the bank. What do you do next? Well, hopefully, if you purchased the property under the appraised value and you put the standard 15 to 20 percent down, the property you purchased has some equity that you can tap into. We can take advantage of that equity by taking out a Home Equity Line of Credit or HELOC for short. In this article I will explain what a HELOC is and how you can use it to acquire more investment properties.
What is a HELOC and how does it work
A Home Equity Line of Credit is a loan that is backed by some qualifying collateral such as a primary home or investment property. Opening a HELOC account versus doing a cash-out refinance has several advantages: the closing costs are generally much less, you only pay interest on money that you withdraw from your account, you can borrow money and pay it back as you please, and you are not increasing the loan amount on your original mortgage or increasing the length of the loan.
Understanding equity
Equity is the difference between the value of the property and the balance remaining on the loan, also called the debt balance. Assume you purchased a property for $200,000 using a conventional mortgage with 20% down and the appraised value came back at $210,000. Therefore, you now have $50,000 of equity in that property.
Equity = $210,000 - ($200,000 x (1 - 0.20)) = $50,000
What can you do with equity
If you have enough equity in your primary home or investment property you can take out a HELOC against that equity. This money can be used for anything you wish. Because we are in the business of compounding our money, the HELOC would best be used for acquiring more investment properties. We can then use that money as a down payment for another mortgage— just make sure to disclose to the mortgage lender that some or all of the down payment money is borrowed.
To use the HELOC you can directly transfer cash into your bank account for purchases. You are also issued checks from the bank to make purchases directly from your HELOC account.
How much credit are you given
With a HELOC, a lender will lend a certain percentage of your property’s loan-to-value (LTV). Similar to the scenario above, suppose your property was appraised at $210,000 and now your current loan balance is $135,000. This means you have $75,000 in equity in that property. If your lender offers an 80% LTV, you will receive a HELOC for $33,000. Here's the math:
(Appraised Value x LTV) - Remaining Loan Balance = Potential HELOC Value
or
($210,000 x 0.80) - $135,000 = $33,000
How do interest and payments work for a HELOC
Lenders offer several variations of the terms of a HELOC, but a popular HELOC structure is an interest only loan where the interest rate fluctuates and typically is tied to the Prime rate. In our case, our lender offered us a non-owner occupied HELOC with an interest rate of Prime + 1.0%. As of February 6, 2020, the Prime rate was 4.75%.
This HELOC has a draw period and a repayment period. The draw period is when you can withdraw money from the HELOC while making interest only payments. This period is usually 10 to 15 years and if only minimum payments are made during the draw period, the loan balance will not decrease. Following the draw period is the repayment period of 20 years. This is when it is required to make both principal and interest payments on the loan in order to pay off the balance.
Getting a HELOC on an investment property
Many lenders offer HELOCs on primary residences and only a few will offer a HELOC on an investment property. Lenders are reluctant to issue a HELOC on an investment property because they generally view it as more risk. When searching for a lender try calling both regional and national credit unions to find out the types of HELOCs they offer. Usually credit unions will lend on an investment property at a slightly higher interest rate with less of an LTV than primary homes. Many lenders also require that the investment property that the loan will be taken out against has a lease in place.
How to use a HELOC to build your rental portfolio
Building a rental portfolio takes time and money, so real estate investors are always looking for ways to acquire more properties with very little money down. A popular strategy is to use a HELOC as the down payment to acquire more investment properties. Of course, it is important that you make sure you’re not over-leveraging yourself by going this route. If you use your HELOC for a down payment on a new investment property, I strongly suggest having a plan to pay the HELOC back as quickly as possible, preferably within twelve months. HELOCs usually have variable interest rates. If you were planning on paying back this loan over a five-year period there is a higher risk of rates increasing during that period compared to if you paid back the borrowed money within one year. This happened to a lot of home owners and investors during the 2008 housing crisis when the Prime rate increased from 4.00% in May 2004 to 8.25% in July 2008. Their monthly mortgage payments increased above what they could afford, which caused many people to fail making their mortgage payments and having their properties foreclosed on.
A real HELOC example
I’ll give you an example of how we used our HELOC to acquire our third rental property:
• One of our rental properties had $48,000 of equity in it due to us acquiring it at a great deal and doing some minor rehab work to increase the value of the property
• We were granted a HELOC of $24,400 with a variable interest rate of Prime + 1.0% with a 10-year draw period
• Purchased a rental property for $123,000 with a 30-year conventional loan and a 15% down payment ($18,450)
• Of the $18,450 down payment we used $15,000 from our HELOC
• Created a plan to pay back the $15,000 in one year by making monthly payments of $1,250
Since our HELOC is interest-only payments for the first ten years, our first payment due was $69.93. The amount due each month decreased as we paid back more of the principal. But if we had only paid the amount due each month, which is only interest, we wouldn’t have paid down any of the principal and would be at risk due to the variable interest rate. I am happy to say that we are about to finish paying back the $15,000 of the HELOC this month in February 2020 as we originally planned.
Getting a home equity line of credit on an investment property takes some work, but it is definitely possible once you find a lender willing to issue you the loan and you have adequate equity in the property you want to use as collateral. HELOCs provide several advantages such as the facts that you only pay interest on money that you withdraw from your account, and you’re not increasing the loan amount or length of your original mortgage. The money from the HELOC can be used for rehabs to add value or even down payments to purchase additional investment properties. If you have enough equity in your property, you can make an “all cash” offer on a new investment property and get an even better deal. Leave a comment if you have a HELOC on an investment property and would like to share your experience.