3 Risks and Drawbacks of Using Home Equity When Investing
Life isn't all peaches and cream when you are dealing with home equity loans and lines. They sound great, but you need to understand the risks inherent in such loan products. If the funds are misused, tapping into your home equity can be disastrous to both your real estate investing business and your personal finances. Because a home equity loan is based on the equity in your primary residence, the lender can place a lien on your home; if you don't pay the money back, the lender will then foreclose on your home and kick you out on the street, severely damaging your credit in the process.
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The obvious solution is to simply pay your bills. If you do, you don’t need to worry, right? It’s not quite that simple, actually. You need to be aware of a few more dangers and pitfalls. Don’t let this information scare you, but you need to know about these risks so you can prevent yourself from making the same mistakes other investors have made.
3 Risks and Drawbacks of Using Home Equity
As you learned earlier, during the mid-2000s, banks were allowing home-owners to take out far too much equity in their home, a condition known as “over-leveraging.” Although banks are no longer providing 125% loans, many will still allow you to take out up to 90% of your home’s value. Is 90% too much?
That is a matter of personal opinion, but understand that values go up and values go down. As of the writing of this book, values are increasing around the country at a rapid pace. As a result, we may see a decline in values in the future (what goes up must come down!), though no future is certain.
If you obtain a 90% LTV loan on your primary residence and property prices drop 20%, you'll quickly find yourself underwater and will be unable to sell your home without coming to the closing table with a significant amount of cash or doing a short sale. Leverage can be a great thing, but over-leveraging can be dangerous because it limits your options. If you don't plan on selling, and you have a fixed rate mortgage, being underwater may not be a big deal to you, because your payment won't change. However, over-leveraging does remove options, and having options is key to success in real estate. The more options you have, the more opportunities you'll have for success.
2. Less Cash Flow
Additionally, by using your home’s equity to fund a down payment or the entire purchase price of a property, you are decreasing the amount of cash flow you would normally receive. For example, when we talked about Jessica and her use of $18,000 of her home equity line of credit to fund her real estate down payment, note that her monthly interest-only payment on that $18,000 was $60 ($18,000 x 4% / 12 months). Although this is not a huge number, it is $60 less that Jessica gets to keep.
Therefore, if you plan on using your home equity to fund your real estate purchase (or even just the down payment), getting a killer deal on the property is even more imperative, to make up the difference.
3. Adjustable Rates
A third danger of home equity loans and lines is something I've touched on a few times already: the potential for an adjustable rate. Each lender will have different terms, rates, fees, and requirements for their loan products, but if you end up with a lender who offers only an adjustable rate loan, it's extremely important that you fully understand what you are getting into and the potential for what could happen. I call this Worst Case Scenario Analysis, and it's helpful to use when considering an adjustable rate loan.
Essentially, I like to look at what the worst case payment would be for that loan, and if it would still make the deal work, I'll consider doing it.
Let's look at the example of Jessica, who used an $18,000 home equity line of credit to fund her down payment. Because the loan was not fixed, her interest-only payment could change. If you were to look into the fine print of her line of credit (which Jessica did before taking out the line), you would discover that the line of credit was capped at increasing by no more than 2% per year, for a maximum interest rate of 24%. So, let's do a Worst Case Scenario Analysis on this deal and see how it pencils out:
- Current loan amount: $18,000
- Current interest: 4%
- Current minimum payment: $60
- Worst Case Scenario loan amount: still $18,000
- Worst Case Scenario interest: 24%
- Worst Case Scenario minimum payment: $360 per month
Wow! You can clearly see the danger of an adjustable rate loan or line of credit in this example. Jessica's initial payment was just $60, but if interest rates were to go crazy, she could end up paying closer to $360 per month for that money!
So the question is, is it worth it?
For Jessica, the answer was yes. She knew that the loan could only increase by 2% per year, so it would take a decade to reach its max, and Jessica planned on snowballing that debt and paying it off in just a few years. Additionally, Jessica bought a deal with an incredible amount of monthly cash flow, so she knew that even if the worst case scenario happened, she would still be able to make the payment using nothing but the cash flow.
The key to using the Worst Case Scenario Analysis is fully understanding the Worst Case Scenario. Dig into the fine print from your potential lender and find out how bad things really could be. On a recent variable rate mortgage I received, I learned that the interest rate was capped at 11%, meaning it could never climb higher than 11%, no matter how high the market rates might rise. When I looked at the numbers and ran it through a Worst Case Scenario Analysis, I discovered that at worst, my payment would increase from $600 per month to $800, but because I’d be receiving almost $2,000 a month in rental revenue, I could handle the worst case scenario and receive slightly less cash flow if everything went sour.
[This article is an excerpt from Brandon Turner’s The Book on Investing in Real Estate With No (or Low) Money Down.]
Do you use home equity to invest? Why or why not?
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