Have you ever had an idea brewing in your head for years and then woken up one day and decided—no excuses—you’re going to just do it?
And you do, going so far as to execute it with the fervor you had dreamed about. You’re unstoppable!
This is the attitude I had the day I jumped into real estate full time.
However, after rehabbing a few properties, my progress came to a standstill. I was held up by the second-to-last “R” in the BRRRR strategy—the dreaded “refinance.” I wouldn’t have more cash to deploy in more deals until I was able to refinance.
Limited capital is the single biggest reason newbie investors are unable to scale. But I wanted to avoid knocking on the doors of private lenders or exploring partnerships. To keep growing my real estate portfolio, I had to find more capital within my existing properties.
And I did! How? Through the power of home equity.
In one year, I grew my portfolio from three to 20 properties by turbo-charging the BRRRR strategy with home equity loans.
How Does a Home Equity Loan Work?
As the economy has improved during the past few years, most of us have seen our property values rise—especially in the hottest real estate markets. There are three ways to tap into this equity: selling, cash-out refinancing, or borrowing against the equity.
If you’re locked into a good interest rate, you may not want to sell. This is when exploring home equity loans is a viable option.
What Is a Home Equity Loan?
This strategy doesn’t require selling your primary residence or refinancing the existing mortgage on it. Instead you’re borrowing against the property, tapping into its equity. This is also possible with rental properties that are either owned outright or have high equity.
With a loan secured against the equity of your property, you can free up funds to further your real estate portfolio.
Home Equity Loan Rates and Other Calculations
Home equity loans are distributed in a lump sum, and the interest rate is fixed. According to Bankrate.com, today’s average home equity loan rate is 7.94 percent.
But what is home equity, exactly? And how much can you borrow, anyway?
Let’s talk about the concepts of market value and loan to value (LTV). For simplicity’s sake, I’m leaving closing costs out of these equations.
Market value in simple terms is what the home is worth. It’s best to hire an appraiser to determine the true market value, but alternatively, you can save around $600 and get good feel for what it likely is based on a comparative market analysis (CMA).
Say you own a home with a market value of $100,000. If you own it outright, you have $100,000 of equity in it. But if you have a mortgage of $45,000, you have $55,000 of equity in it.
Some lenders will lend you up to 90 percent of your equity in your primary residence. This equates to a 90 percent LTV.
So, in a $100,000 house with a $45,000 mortgage, that means you can borrow:
$100,000 X 0.9 – $45,000 = $45,000
This is not the case for a rental property. Most lenders offer 75 to 80 percent LTV on rental properties.
In a $100,000 rental house, that means you can borrow:
$100,000 X 0.75 – $45,000 = $30,000
Of course, these loan opportunities come with some pretty stringent conditions. For instance, it can be difficult to secure a home equity loan if you have bad credit, don’t meet certain debt-to-income ratio requirements, and so on.
What is BRRRR?
As mentioned above, I used home equity loans to employ the BRRRR method of investing.
For those unfamiliar, BRRRR stands for buy, rehab, rent, refinance, and repeat. It is one of the most powerful strategies in real estate to grow one’s portfolio.
A key component of this strategy is purchasing a property that needs work. The next steps are rehabilitating it, renting it out (also known as stabilizing), and then approaching a bank for refinancing and pulling the original funds out to do more deals.
BRRRR and home equity loans are the perfect match. Why? Investors who use this type of funding specifically for home renovations can deduct the loan’s interest on their taxes.
How to Borrow Money Against a Property’s Equity
Let’s talk about the borrowing part. A home equity loan isn’t the only way to borrow against the equity in your property. A home equity line of credit is another option. Here’s a little more info about each.
Home Equity Loan
With a home equity loan, you can take all the cash up-front in a lump-sum payment and repay the loan over time in fixed monthly payments. The interest rate will also be fixed for the life of the loan, which is amortized over an agreed upon number of years.
Home Equity Line of Credit
Another option is to establish a home equity line of credit (HELOC). This type of loan is somewhat similar to a credit card.
Unlike home equity loan interest, HELOC rates are variable. Currently, the average HELOC rate is 6.51 percent, according to Bankrate.com.
Once approved, lenders offer a line of credit up to a specified amount. Instead of a lump-sum payment, HELOCs come with a set draw period (usually 10 years) during which you can continue to withdraw money as needed.
The HELOC option is very attractive to BRRRR investors, as he or she will be able to pay off this money when the property is refinanced, then repeat this process over and over. What’s even better, you only pay interest on what you use from the available funds.
Which Option is Best?
Having tried both, I can say that if you are using home equity loans or HELOCs as part of the BRRRR strategy, they are both fantastic tools to scale.
Yes, HELOCs do give you more flexibility in the sense that you can treat your HELOC like a credit card. Borrow money when you need it to purchase and rehab a property, and then pay it back once you rent and refinance, then repeat.
However, you can replicate the same model with a home equity loan. Simply utilize the method outlined above to take a loan out against the property’s equity, thereby rolling the funds into the next deal.
After speaking with multiple banks about this, I have realized that local credit unions are the best bet for these loans. Reach out to several in your area in order to get the best terms.
How I Grew My Portfolio With Both Home Equity Loans and HELOCs
Now for the meat of the story. I used both strategies in order to drastically grow my real estate portfolio—fast.
Here’s how I did it, step by step:
- Allowing Equity Growth: One of my rentals had about $150,000 in equity. We had purchased the house in an up-and-coming neighborhood, fixed it up while we lived in it, and stayed there for six years , giving it a chance to appreciate in the growing market. When we finally moved to a new home, I rented out this property and was making a pretty great cash flow.
- Obtaining a Home Equity Loan: I then started calling local banks and credit unions, asking if they’d be willing to take second position on this property that was now a rental. I didn’t realize how difficult this would be to accomplish. But after many failed attempts, one credit union finally came through. They ended up giving me a home equity loan without even doing an official appraisal on the property. I could have opted to hire an appraiser and received a higher loan, but I still wanted this property to cash flow, so I left some equity in it.
- Deploying the Funds: I used this money as 15 percent down (with closing costs that came out to be around $20K) with a hard money lender who I already had a relationship with to borrow acquisition and construction funds for four single family homes.
Here is what a typical purchase looked like (I rounded the numbers to make it easy):
Purchase Price: $70,000
Construction Budget: $30,000
15% Down Payment: $15,000
Closing + Financing Costs: $5,000
Total Cash Needed to Purchase: $20,000
First Up-front Contractor Payment: $5,000 (repaid by lender by end of project)
- Refinancing and Pulling Cash Out: After I was done rehabbing the properties and renting them out, I started calling local banks, inquiring about the ones that didn’t have seasoning requirements and applying for permanent loans. All said and done, when I refinanced the properties, I was able to pull out about $30,000 on average per property while still making a cash flow of $500 per month for each property.
Market Value After Rehab and Rent: $160,000
Closing Costs: $2,500
Other Costs (i.e., Holding Costs): $2,500
Cash Out at 75% LTV: $30,000 (which is $10,000 more than I invested)
Equity in the Property: $40,000
- Rinse and Repeat: I would have been able to pay off the loan within less than a year of borrowing the money. Instead, I kept going and rolled the money to acquire more single family properties, repeating the BRRRR process again and again. And the same loan has financed my latest nine-unit acquisition.
Because this worked so well for us, I took out another HELOC against my current primary residence, which we rehabbed while we lived in it. This loan will fund a 15- to 30-unit building that I’m currently in the market for.
Advantages of Home Equity Loans and HELOCs
There are certainly advantages to utilizing these borrowing option, including:
- Interest rates for such loans are significantly lower than credit card interest rates. I’ve seen some aggressive fellow investors use credit cards for down payments for their BRRRR strategy. These are much lower risk options.
- This debt is looked at more favorably by banks than credit card debt, giving you a higher chance of getting approved for permanent loans in the future.
- Most importantly, you can keep an existing property, furthering your portfolio by avoiding selling.
Drawbacks of Home Equity Loans and HELOCs
Would using this strategy mean that you’d be more leveraged? Absolutely! It goes without saying that the deals that you do (especially in the market cycle we are in) need to be not just good deals—but great.
That being said, here are a few drawbacks:
- Your debt-to-income ratio (DTI) takes a hit. When you borrow money in your own name, your debt-to-income ratio goes up. If you borrow money under an LLC but personally guarantee it, your global DTI comes into play. It is harder for banks to give you permanent financing when they see that your DTI doesn’t meet their standards. So, it’s best to only take on an amount of debt that will keep your DTI at a good level.
- There’s lower cash flow on properties with home equity loans, meaning they aren’t as profitable until the loan is paid off.
- It requires discipline to not consider the money that came out of a BRRRR as income and propel it to further one’s portfolio.
Considering Alternatives: Should I Refinance or Sell Instead?
A cash-out refinance may have similar benefits to a home equity loan. Cash-out refinance simply means converting an existing mortgage into a new one at a higher amount based on the equity. It translates into a single mortgage with higher monthly payments than before because of the increased amount borrowed.
The great thing about this option is the entire loan can be amortized over a longer period of time than a typical home equity loan. Plus, the interest can be fixed.
The disadvantage is that the home equity loan can be paid off and the monthly payment would go away. But once you refinance, you don’t have that benefit.
Selling is always another option, particularly if tapping into the equity hurts the cash flow to a point where the original investment is not profitable anymore. Keep in mind, though, that closing costs and capital gains will lessen your cash-in-hand after selling a property.
What are you doing with your property that has appreciated? Are you selling, refinancing, or looking into borrowing against the equity with a home equity loan or HELOC?
I’d love to hear from you in a comment below.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.