One of the biggest challenges many real estate investors face is where to find funding for their deals. Whether you use hard money or a traditional lender, financing capital is needed to close deals. Not only to close deals, but also to make any improvements or to run a profitable rental property. While finding capital can be a struggle at times, it may be closer to you than you think. If you have an existing portfolio, you may be able to utilize your current equity in the way of a home equity line of credit.
Equity can be defined as the difference between the amount owed and the value of a property. Since ‘value’ is a subjective term, equity is always a moving target. We may think our property is worth 200,000 dollars, but we never really know until we put it on the market and see who takes the bait. A home equity line of credit (HELOC) utilizes the available equity in the way of a new mortgage on the property. Any existing first mortgage is kept in place with a new second lien added. This lien is based more on available equity than anything else. The underwriting and approval methods are similar to a first mortgage with more emphasis placed on the amount of equity. As a real estate investor, this can be a viable option of finding funding for your next deal. With most things in real estate, there are always pros and cons. Here are a few pros and cons of using a home equity line of credit.
Low rates and terms. A HELOC has a different set of terms than your traditional 30-year fixed mortgage. Most HELOCs are based on the prime rate or another index, which is currently hovering near all-time lows. Some lenders provide fixed rate options, but those are more for second loans rather than liens. Even though the rate is adjustable, it is currently well below fixed rate alternatives with no imminent sign of increase. HELOCs also offer low monthly interest payment options. With your loan, you only have to pay the interest for the first ten years. This allows you to increase cash flow and earn more on your money.
Flexibility. With a HELOC, you only pay on what you use. If you take a line out for 50,000 dollars and you only use 20,000 dollars of it, your repayment is based on the $20,000 – not the full amount. This will keep your payment as low as possible on the money you actually use. As we mentioned, the interest only repayment option is just that, an option. You still have the ability to increase your payment at any time but are only on the hook for the interest portion.
Portfolio expansion. Using funds from a HELOC on one property allows you to quickly expand your portfolio. You are using money that you weren’t doing anything with and earning an estimated 12 to 24 percent on a new purchase. On any subsequent deal you close, you are growing your portfolio. The best part is you are doing it with your own funds and on your own terms.
Additional loan payment. Even though your payment is reduced, it is still a new payment on the property. In a perfect world, you would use this line to grow your business. What sometimes ends up happening is that the line gets used for other items. So instead of growing your business, you end up adding to your debt. By maxing out the line, you will also end up lowering your credit score due to the lack of available balance.
Balloon option. The HELOC has an interest-only option for the first ten years. Since no principal is applied during that time, it must be made up in the subsequent ten years. This new monthly payment is often much higher than the interest-only amount. You can pay your loan down or off any time in the first ten years but after that, the principal is added to the payment.
Equity reduction. Even though equity is an inexact number, it still is important. Any new loan you obtain is added to the total amount owed on the property. The more equity you have, the greater number of options that are available. Equity allows you to sell or refinance when values go up. If values shift down and there is no equity, you may be forced to keep the property until things change.
As you consider whether or not a HELOC is for you, there are a few things to remember. The first is that like any other loan, you need to qualify. Simply having equity does not guarantee you of approval. The underwriting is not as strict as with a first mortgage, but you still need to have a strong credit score, low debt, and high income.
The second factor is to consider your alternatives. Hard money is a viable option but when you add up the fees and interest, repayment on a HELOC may be a better alternative. Before you do anything, you should also consider what else is out there and always think about the long term. For every investor who tells you to take advantage of a HELOC if you can, there will be one who is strongly opposed. Do your own homework and figure out what it is best for you and your business.