What’s Better, a Home Equity Loan or a HELOC—(Home Equity Line of Credit?)
Traditional bank financing can be a challenge for anyone, especially those who need it for the first time. I was trying to get traditional bank financing to do my real estate deals when I was a self-employed contractor, but I was shut down. This is typical, since all self-employed borrowers are up against more stringent guidelines for achieving funding than W2 borrowers.
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I just happened to take a real estate investing course to get some credits towards a real estate broker’s license, and the first day of class the teacher took our textbook and threw it in the trash. He asked the class how many of us owned rental properties. A few hands went up. He then asked how many of us had credit cards, and all the hands went up. Back then cash advance fees were almost nonexistent, which led to his next question: why weren’t we using them to purchase real estate, after all that was our business. We shouldn’t let traditional financing stop us, Realtors of all people, from buying real estate. He said it was like stockbrokers not owning stock.
That night I went home and I couldn't sleep. I knew I no longer had a W2 and couldn't get a traditional mortgage to purchase a fixed up rental let alone a "handyman"—a property that a bank won't typically finance without a certificate of occupancy at the time of closing. So I checked with the bank to verify that if I did own a property "free and clear" (due to the fact that the acquisition and fix up costs would be on credit cards) that they would be willing give me 65-70% of the ARV (after repaired value) in the form of a home equity loan. Then I bought a property with credit cards ($13,000), fixed it up with a credit card (all in at $18,000 including closing costs), moved a tenant in ($650 in rent), and had the property appraised for $37,000. That enabled me to refinance the property with a 20 year, fixed rate, home equity loan (in the amount of $24,000). Bingo! My teacher's idea worked. Even with the shorter-term loan, I still cash flowed and walked away with a few grand after the credit cards were paid off ($6,000 tax-free since it was a loan) because the loan-to-value was so low.
From Credit Cards to Home Equity
I continued using this strategy to buy more properties. As a result, my credit card limits were raised significantly, not to mention the rewards points that were giving me cash back and free vacations. The biggest benefit of all was that a few years later there was an uptick in the real estate market, and the next thing you know I had a couple million dollars in equity. Then, instead of using credit cards, I made it a point to tap into that equity (after all, the rate of return in the equity of your property is 0%). At one time, I had 11 home equity lines of credit (HELOCS). These were definitely a very large factor in my overall wealth accumulation, whether funding for acquisition or renovations for myself, or for hard money loans to friends, or to what I invest most of my equity in today: re-performing notes, primarily 2nd mortgage notes.
So, why 2nd mortgages, and which is better as an investment, a home equity loan or a HELOC?
First, let's look at their similarities. Both are second mortgages and both are secured to the property. Home equity loans are usually a fixed rate mortgage, with a specified term (e.g. 20 years), with a specified payment (Principle + Interest), that is amortized over the term. Home equity loans are typically used at the time of purchase as a means to avoid PMI (Private Mortgage Insurance that's required because the borrower's putting less than 20% down payment). They can also be used post-acquisition for a home improvement loan, which can be used to fund improvements, such as a swimming pool or an addition.
The HELOC is usually a variable rate mortgage with a fixed draw period (e.g. 10 years), and it usually amortizes (P + I payment) over the remaining term. HELOCS may be used at acquisition and at closing to avoid PMI. They can also be added at a later date as a line of credit, similar to a credit card or checking account access that’s backed by the properties equity, in other words secured by the equity in the property. HELOCS are a great tool to utilize for asset protection and for liquidity.
A real estate attorney, several years ago, showed me how HELOCS are an excellent form of asset protection even if your house is paid off:
Example: Fair Market Value is $500,000, Mortgage Amount is $200,000, and Equity is $300,000
The $300,000 in equity can be a target for someone if they want to file a lawsuit against you. But, if you have a HELOC (for 90% fair market value = total $450,000) it would be an accessible $250,000—which is the remaining balance after you deduct the first mortgage. This is the case even with a zero balance, meaning that you haven't drawn down or utilized any of the money yet (so you haven't made any interest payments). Then, if an attorney for someone attempting to file a lawsuit against you is trying to check your available assets, they will see that you technically owe $450,000 at the courthouse and not the $200,000 mortgage you really owe. The real estate attorney also suggested having HELOCs for as many properties and for the highest amounts as possible for liquidity. If you went to the bank after being out of work for say nine months due to illness and asked for a loan you would be denied because you don't have a source of income. Hopefully, if your HELOCS are in place prior to becoming ill or disabled you will have cash readily accessible. As you can see, liquidity with HELOCS is an important concept that is critical to your wealth accumulation and preservation, as is investing of HELOCS.
But Let’s Now Look at Both as an Investment.
For a lender, they both work well as investments in most cases. Both types are secured by equity (when we’re in an up-market), and both were taken out by good borrowers with clean title. Equity loans are usually very predictable income streams for the lender because it’s a fixed payment. HELOCS on the other hand only pay interest on when borrowed or accessed, other than potential yearly access fees, but the interest rates are variable (usually with a cap) that actually protects the lender in times of interest rate volatility. So, both work very well.
The reason both types of loans work well for me, as the lender, especially when investing in re-performing second mortgages, is that I’m really investing in a new payment plan that’s purchased at a discount. If I’m buying a re-performing HELOC, this means it first went nonperforming—the draw period was canceled and the loan was termed out when it defaulted. So even though I’m investing in what once was a variable rate, secured line of credit, the HELOC modification is termed out with a new payment plan, fixed interest rate and term, and in essence acting just like a typical home-equity loan.
Either way, both types of loans have been valuable tools for building my portfolio of both paper and hard real estate assets. I am curious to see how other investors are using these tools to invest in, as well as build their portfolios.