One of the biggest challenges many beginner real estate investors and prospective homeowners face is where to find capital. But have you ever considered looking into the HELOC pros and cons?
Finding financing is necessary for investors to close deals, make property improvements, or run a profitable real estate investing business. 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.
As a real estate investor or homeowner, this can be a viable option for finding funding for your next property. With most things in real estate, there are always pros and cons. Continue reading to discover the pros and cons of a home equity line of credit.
What Is A Home Equity Line of Credit and How Does It Work?
A home equity line of credit (HELOC) utilizes the available equity in the way of a new mortgage on the property. With a new second lien added, any existing first mortgage is kept in place. 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.
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, but we never really know until we put it on the market and see who takes the bait.
A home equity loan results from a borrower using their personal home equity as collateral to take out a loan. It is usually used to finance big investments and expenses. Taking out a home equity loan usually requires the borrower to have great credit and a good loan-to-value ratio on their property. Home equity investing can be a great tool for responsible borrows to make home repairs, pay for education, or resolve the debt. Now we will break down the HELOC pros and cons to be aware of.
Benefits Of 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, 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.
Quick Approvals: In terms of home equity loans, HELOCs tend to follow a shorter timeline. The reason for this is because the underwriting process is much simpler. Your lender should provide an accurate timeline, though approvals are faster on average than other financing methods.
Flexibility: With a HELOC, you only pay on what you use. If you take a line out for 50,000 dollars and 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. According to Corrigan Duffy, Owner of Corrie Cooks, one of the best benefits is flexibility. “In my opinion, unlike traditional loans, which are paid back in one single sum, a HELOC allows you to borrow as you need it. Lenders assign credit limits to authorized customers, similar to credit cards so that they can use the line to get cash”. 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.
Low or no fees: Traditional mortgage applications can cost up to $500 in fees alone, but with a HELOC the case is much different. Lenders don’t charge the same fees for home equity line of credit applications, and some owners may find they avoid them altogether. There may still be charges for attorneys or title searches; however, HELOCs are associated with fewer administrative costs as a general rule.
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.
Tax benefits: The interest that you pay on a HELOC is tax-deductible if you itemize your deductions. If you are a single filer you can deduct up to $50,000 of the interest paid, while if you are married and filing jointly you can deduct up to $100,000 of interest paid from your taxes.
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Disadvantages of A Home Equity Line of Credit
Loan collateral: Perhaps the biggest disadvantage, or risk, of a HELOC is that your house is secured as collateral. This can be a particularly daunting threat for anyone using a HELOC on their primary residence. After all, if you fail to make loan payments, the bank could foreclose on the property.
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 lower 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 principle 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 the principal is added to the payment after that.
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 available options. 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.
Penalties & fees: Always be sure to read the fine print when utilizing a HELOC loan. According to Andrew Latham, a certified personal finance counselor and the managing editor of SuperMoney, “there are hidden fees many people overlook when opening a line of credit.” As a result, Latham strongly recommends “checking how much your lender will charge in annual fees (it’s typically around $100 a year) and whether they charge prepayment penalties.” Some lenders will charge annual fees or even inactivity fees if the credit goes unused. Furthermore, users should also make sure they are aware of any penalties for paying back the amount early. “Typically, the early closure fee is around $500 and is triggered if you pay off your HELOC and close it after just 12 to 36 months into the loan,” says Latham.
Unpredictable Payments: HELOCs depend on interest rates, and as an adjustable-rate loan payments can fluctuate quite a bit over time. This factor is yet another disadvantage to be aware of before using a HELOC, although it should not entirely discourage your use of the loan. Some investors will search for lenders willing to convert to a fixed-rate loan in time—allowing them to avoid changing interest rates.
HELOC vs Home Equity Loan
Both HELOC and home equity loans involve tapping into the equity you have built up in a property, though they work differently. A HELOC operates similarly to a credit card, with homeowners only accessing the funds they need. With a HELOC loan, interest is only paid on the amount homeowners use. Interest rates can be adjustable or fixed depending on the lender. On the other hand, a home equity loan is a lump sum amount that homeowners receive. Interest is paid on the entire home equity loan, as the amount is distributed at one time. Home equity loans typically have fixed interest rates.
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Is A Home Equity Loan Right For You?
Deciding between a HELOC vs. home equity loan will depend on what you need the funds for. If you are tapping into your home’s equity to purchase another property, then a home equity loan may provide the money you need for a down payment. However, if you are working on a renovation project or need smaller amounts of money at once, a HELOC will allow you to withdraw funds on an as-needed basis. As always, be sure to research both options (and their respective interest rates) before deciding the right one for you.
Home Equity Loan vs. Personal Loan
Above we touched on HELOC pros and cons, but how do you know it is the right decision for you? You may be wondering why some people would opt to take out equity on their home when they could just as well take out a personal loan from their lender.
One of the main disadvantages of home equity loans is that they require the property to be used as collateral, and the lender can foreclose on the property if the borrower defaults on the loan. This is a risk to consider, but the interest rates are typically lower because there is collateral on the loan.
Alternatively, a personal loan is unsecured and is usually associated with higher interest rates. If timing is considered, a borrower can typically take out a personal loan much faster than a home equity loan. At the end of the day, both loan options have unique advantages and disadvantages, and it is a personal decision to be made by the borrower based on their circumstances.
How To Calculate Home Equity
To calculate how much equity you have on your home, you will need your property’s value and how much you owe on your mortgage. Subtract the amount of money you owe on your mortgage from your property’s value. Depending on your financial record, lenders may let you borrow up to 85% of your home equity. Since you are using your home for collateral, the lender can foreclose on your property if you default on your payments.
The combined loan-to-value ratio is the amount you owe on outstanding home loans divided by the market value of your property. A higher ratio means lenders will less likely let you borrow more against the home’s value.
Let’s go over a simple example: If your home is worth $400,000 and you owe $200,000, the formula to find your loan-to-value ratio is $200,000 / $400,000 = 0.5. This is a loan-to-value ratio of 50%. If the lender allows a combined loan-to-value ratio of 80%, they will grant you a 30% home equity loan.
It can be tricky to calculate your own home equity, but luckily, several great online calculators are available. For example, try to use the easy-to-use home equity loan calculator provided by U.S. Bank.
When deciding to utilize a HELOC, a home equity loan calculator is strongly advised to determine your potential payments and costs associated with the loan.
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 your 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. This goes without saying for any situation, but you should always weigh the HELOC pros and cons before proceeding. Do your own homework and figure out what is best for you and your business.
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