cash out refinance vs HELOC and starting out strategy

16 Replies

I am a newbie to BiggerPockets and would appreciate some advice. My wife and I have accumulated some savings that I think can allow us to retire comfortably even though we are still young and may be working for another 20 years. I had been a landlord remotely after selling our last primary residence and finally decided to sell it last year. We recently bought another rental property in Austin and want to buy more rental property as I just realized the great investment potential in real estate. 

We have ~$1M invested in mutual funds that we can sell after paying tax on the gain over the years which we can use to invest in rental real estate; we can also do a cash-out refinance on our primary home to free up ~$800K equity. We plan to refinance anyway with cash out or not as it will lower our interest rate, though the cash out option will have 0.125% higher interest rate than the non-cash out option.

Our dilemma is should we do a cash-out refinance or a regular refinance for now? If we do regular refinance, we may take out a HELOC in the future if we need additional cash to invest in rentals. I am leaning towards the cash-out refinance as it allows me to lock in the current low interest rate - I will probably park the cash in stock market while looking for deals in rentals. I understand HELOC gives me more flexibility especially when we are not too sure what/where to invest in now, but I do not like the fact that its interest rate will increase in the future. Is there any problem with this strategy? I have never intentionally tried to become a landlord and real estate investor before and I am starting new even though we have bought and sold multiple primary homes, therefore I would really appreciate any advice on the strategy, where to invest (I am in SF bay area), where/what I should learn...


Thank you so much!

The problem with a refinance is that you aren't actually comparing apples to apples with a HELOC. When you look at 2.5% on an amortized loan you think it's lower than 4% on a HELOC. But it's kind of like one percentage is expressed in Fahrenheit while the other is expressed in Celsius. Suppose you refinance at year 13 of a 15-year mortgage. And suppose the rate you were quoted for that mortgage had been 2.5%. Effectively though, not even counting the fees you paid upfront and will pay to refinance, you will have paid about 8% in simple interest. That number is even higher if you refinance at an earlier point of the loan.

Choose the HELOC. You'll avoid the atrocious fees associated with a refi; you'll get access to gobs of money that you can use on a revolving basis rather than beginning to pay interest on the entire chunk from day one; and you'll never have to debate refinancing again (not unless the bank converts it to an amortized loan at some future time, but if they do that, you don't pay fees because the conversion wasn't your choice and then you have a free refinance.

@Jody Sperling Thanks a lot, Jody! How did you calculate the 8% figure and why is it even high if I refinance in the earlier stage of the loan? I always had the suspicion that there is something wrong with refinancing as it delays the loan completion but could not figure out what exactly wrong. I know over the life time I will end up paying more interest, but if I always invest the money I cash out and if my investment return is more than than loan interest rate I always wins, right?

Regarding the refinance cost, I always do no cost no fee as it gives flexibility in the future to refinance again when interest is lower. I know this gives a higher interest rate but my thinking is similar to above: as long as my investment return is higher than the interest rate, I always wins by refinancing. Is there something wrong with this kind of thinking?

Originally posted by @David O. :

@Jody Sperling Thanks a lot, Jody! How did you calculate the 8% figure and why is it even high if I refinance in the earlier stage of the loan? I always had the suspicion that there is something wrong with refinancing as it delays the loan completion but could not figure out what exactly wrong. I know over the life time I will end up paying more interest, but if I always invest the money I cash out and if my investment return is more than than loan interest rate I always wins, right?

Regarding the refinance cost, I always do no cost no fee as it gives flexibility in the future to refinance again when interest is lower. I know this gives a higher interest rate but my thinking is similar to above: as long as my investment return is higher than the interest rate, I always wins by refinancing. Is there something wrong with this kind of thinking? 

The best way to convert amortized interest is to look at the payment schedule. The only way you actually pay the quoted percentage is if you complete the amortization schedule. The bank front-loads interest meaning your first year of payments are almost always well over 100% interest.

Consider that if you bought a 200k house and put 20% down. You'd finance 160k. The bank gives you 3% amortized on 30 years. Your first payment is $400 in interest and $258 in principal. If you converted that to simple interest, you're paying 155%. Fast forward to year 15 of the loan. Your principal payed on the first month is $429 and the interest is $245. You're still paying 57% in simple interest. But if you consider the total interest paid up to that point, you're still at about 90% interest.

Now it may be true that your property appreciated over that time, which hides the fact that you actually gained very little principal over fifteen years, and the refi will put a bunch of cash in your account, but you can get a HELOC on the appraised value of the property too, which even if they quote you 16%, I'd rather pay 16% than 90%. But HELOCs are closer to 4% at the moment.

@Jody Sperling Thanks for your explanation. I do not understand why the simple interest rate is 155% in your example. Isn’t 155% simply the ratio of the interest and principle in the first month payment? Why do you call it interest rate?

I think interest rate should be defined as the annualized payment divided by the TOTAL amount borrowed (in your example it is 3%); interest rate should not be defined as the ratio of the interest portion and the principle portion of each money payment?

The equation to determine simple interest is principal times rate times time (Interest = PRT). You can determine any interest by running the equation. If you refinance after one month of payments on the example I provided, you paid 155% simple interest.

If you look at one year of interest, which is a more typical T, you’re still paying about 150%. After fifteen years, your rate is still 90%. The average homeowner either sells and rebuys a home or refinances every six years, forfeiting the amortized interest rate and restarting the loan period.

Thanks Jody.

I understand and agree that interest = PRT, however, I think principal in the PRT equation should be the total remaining principal (ie, total money you borrowed that remains to be paid back), not the monthly principal payment?

@david 

@David O. The HELOC strategy is something that I have used with great success in the past. It only works in appreciating markets like the SF Bay Area. Basically, I would pull a HELOC on an A-class property to buy a property in a C/D-class area. The purchased property needed to have the potential for BOTH forced and market-based appreciation. This strategy allowed me to look like a cash buyer. I would then force appreciation and ride the market appreciation wave for 1 year (seasoning period). At the end of 1 year, I would put direct debt on that building and pull of my cash out to pay down the HELOC. Essentially I was reloading the gun.

However, I would be very careful about using that strategy now. As you may know, Wellsfargo pulled back on their LOC's. This could be an indicator of problems to come... It might be a safer bet to lock in a normal loan and eat the financing costs. Just my opinion and you know what people say about opinions...

I wish you the best of luck!

@David O. the HELOC strategy can definitely work, I have been doing it for years. But you must understand that it is a "line of credit", not a loan. It is essentially a giant credit card. A line of credit can be canceled by the bank at any moment. If the bank were to cancel your LOC when you were not expecting it, you could find yourself in trouble. I am just saying that Wellsfargo has made the first move, other lending institutions could follow... or they might not. It really depends on which way you believe the economy will move and what the lenders will do.

If you get a better Loan to Value on the Cash out Refi, I can see doing that for cash reasons. But I dont see any other reasons why a HELOC would be be less desirable than a cash out refi. Anyone have insight into this?

David Green gave a brief answer in a recent video, but Im not sure 100% about how directly he answered the question.

Originally posted by @Arlen Chou :

@david 

@David O. The HELOC strategy is something that I have used with great success in the past. It only works in appreciating markets like the SF Bay Area. Basically, I would pull a HELOC on an A-class property to buy a property in a C/D-class area. The purchased property needed to have the potential for BOTH forced and market-based appreciation. This strategy allowed me to look like a cash buyer. I would then force appreciation and ride the market appreciation wave for 1 year (seasoning period). At the end of 1 year, I would put direct debt on that building and pull of my cash out to pay down the HELOC. Essentially I was reloading the gun.

Hi Guys, sorry for my ignorance - I'm new to this (my wife and are about to close on our first investment property in a couple of weeks)…I generally understand what Arlen Chou wrote above, but when you say "put direct debt on that building", what is meant by that? Is that just refinancing that investment property in order to cover the money from the HELOC so you can pay back the HELOC and then do it all over again (I like "reloading the gun"!)? I guess my main question is - what is direct debt?

Thank your in advance!

@David O. I'm a big proponent of a very specialized 1st position Heloc that's tied to a Zero Balance sweep checking account. With it you get all of the benefits @Jody Sperling mentioned from more traditional Helocs, but that Sweep checking account really brings it to the next level. With that ZBA, all regular banking deposits/idle funds are automatically swept to the balance of your line every night at midnight. So all my regular deposits work much harder than they would in any "high-yield" savings account, tax free. Along with that, there's a 30 year draw period for equity. And to @Arlen Chou 's point/concern, since it's specifically designed to only sit in 1st position, it has staying power more similar to that of a 30 year fixed mortgage. 
It's been an awesome tool for me.