3 Risks and Drawbacks of Using Home Equity When Investing

3 Risks and Drawbacks of Using Home Equity When Investing

4 min read
Brandon Turner

Brandon Turner is an active real estate investor, entrepreneur, writer, and podcaster. He is a nationally recognized leader in the real estate education space and has taught millions of people how to find, finance, and manage real estate investments.

Experience
Brandon began buying rental properties and flipping houses at the age of 21. He started with a single family home, where he rented out the bedrooms, but quickly moved on to a duplex, where he lived in half and rented out the other half.

From there, Brandon began buying both single family and multifamily rental properties, as well as fix and flipping single family homes in Washington state. Later, he expanded to larger apartments and mobile home parks across the country.

Today, Brandon is the managing member at Open Door Capital, where he raises money to purchase and turn around large mobile home parks and apartment complexes. He owns nearly 300 units across four states.

In addition to real estate investing experience, Brandon is also a best-selling author, having published four full-length non-fiction books, two e-books, and two personal development daily success journals. He has sold more than 400,000 books worldwide. His top-selling title, The Book on Rental Property Investing, is consistently ranked in the top 50 of all business books in the world on Amazon.com, having also garnered nearly 700 five-star reviews on the Amazon platform.

In addition to books, Brandon also publishes regular audio and video content that reaches millions each year. His videos on YouTube have been watched cumulatively more than 10,000,000 times, and the podcast he hosts weekly, the BiggerPockets Podcast, is the top-ranked real estate podcast in the world, with more than 75,000,000 downloads over 350 unique episodes. The show also has over 10,000 five-star reviews in iTunes and is consistently in the top 10 of all business podcasts on iTunes.

A life-long adventurer, Brandon (along with Heather and daughter Rosie and son Wilder) spends his time surfing, snorkeling, hiking, and swimming in the ocean near his home in Maui, Hawaii.

Press
Brandon’s writing has been featured on Forbes.com, Entrepreneur.com, FoxNews.com, Money Magazine, and numerous other publications across the web and in print media.

Follow
YouTube
Instagram @beardybrandon
Open Door Capital

Read More

Join BiggerPockets (for free!) and get access to real estate investing tips, market updates, and exclusive email content.

Sign in Already a member?

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.

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

1. Over-leveraging

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.

BRRRR-strategy-deal

Related: FHA Streamline Refinance: How to Lower Your Monthly Payment & Preserve Home Equity

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!

tax-changes

Related: The Home Equity Line of Credit (HELOC) Interest Deduction: What You Should Know Before Filing Taxes

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. ]

hard-money-lenders

Do you use home equity to invest? Why or why not?

Leave your comments below!