What’s Better, a Home Equity Loan or a HELOC—(Home Equity Line of Credit?)

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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.

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.

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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.

Photo: roarofthefour

About Author

Dave Van Horn

Dave Van Horn is President at PPR The Note Co. - an operating entity that manages several funds that buy/sell/hold residential mortgages, both performing and delinquent. Dave has been in the Real Estate business for 25 years, starting out as a Realtor and contractor and moving onto everything from fix and flips to Raising Private Money.

26 Comments

  1. When I heard about HELOC’s, I went down to one of my banks and ask for one on one of my rentals. A week later got it. Bought a property for all cash at 65% of listing price, rehab, rented out and refinance to get all my money back. Did that four times the first year, at zero cost. My Banker found out what I was doing and said he was going to raise my rates. I said go ahead, only had the loan about three months at a time anyway, of course he was kidding. My equity (70%), cash flow and overall wealth went way up because of the HELOC loan. If it wasn’t for the ten mortgage limit would have bought a lot more.

    Really nice job of explaining the different type of loans. Talk about free money….

    • Hi Jim,
      I agree with you, and I was in a similar situation. Here’s something I did that might be a potential alternative. I ended up lending that money out from my HELOCS and my self-directed IRA to fellow investors, usually for a short term (one year or less) rehab loan, 65% loan to value, and typically its 15-18% interest only with 0-6 points. And, typically, I’m borrowing the money from the HELOC for less than 4%. My fellow investors would turn around and do the same for me, to help fund my future deals. After all, they can’t lend their IRA money to themselves.

      Best,
      Dave

    • Stu,

      According to Wikipedia, HELOCS became popular in the United States in the early 2000s. I didn’t really see them prior to that, because I started using HELOCS in 2003/2004. So, I think that’s accurate.

      Best,
      Dave

  2. I’m a bit confused on this. Let’s say I’d like to get a HELOC on my current residence to purchase a rental property or buy a new primary residence and turn my current one into a rental. How much money can you pull out? Up to 80% LTV right? Would a HELOC or a second mortgage be the best option for this strategy?

    • If you pull out the equity loan while still a primary you may qualify for up to 90%. but as for what is better to purchase the next property is partially personal preference as to whether a HELOC or not, and what your plans and intentions are for the next property.(e.g. rent ready vs. ‘as is’)

      • Dave,
        First off, thank you for the reply. My plan is to buy a new primary residence and rent the house I am currently living in. I would be using the HELOC for part of the down payment on the new house. I guess my question is this; Is this a good use of leverage?

        • DJ,

          It could be a good use of leverage, but It depends on two big factors. Are you cash flowing enough from the rent to make the payment on your 1st and your new HELOC? And, what is the additional HELOC money on your new primary doing for you?

          Best
          Dave

  3. I can’t find a bank that will do a heloc on an investment property…only on my primary…or else I would have gotten a heloc already. Am I missing something or am I just not hitting up enough banks to find a bank that will heloc an investment property???

    • Hi Jimmy,

      You’re right. It’s a sign of the times–it is harder than usual, especially on investment properties. But, banks are coming around, and it wouldn’t hurt to hit more banks. I always had to shop around, even in a good market, and sometimes I hired a broker. I even took a banker to lunch every once and awhile to pick his brain on what’s out there. Are you unable to find them or are you getting turned down? Also, have you considered getting an unsecured business line of credit for your LLC? It might a helpful alternative.

      Best,
      Dave

  4. This is a very timely article for me and I appreciate the detailed information on HELOCs. I have been considering applying for one on the investment property I purchased just over a year ago for either asset protection or further investing. So, if I were to apply and get one, I don’t necessarily have to use the money until I need it and won’t have to pay interest on it until I do?

  5. Hi,

    Thanks for the info.
    I was wondering, if I had money sitting around that I wanted to lend to other fellow investors, how would I setup the structure and who would manage it for me? The title company?

    For example, lets say I had $100K and I was going to loan that for 15% interest with 5 points, would you set a balloon payment of say 3 years?

    • Hi Bruce,

      Well, the reason mine are easy to manage is I have a note, a mortgage, and a deed in lieu drawn up by my title company. And, my typical rehab loan (with your example) would be a $100,000, 15% Interest Only, 1 year balloon, with 5 points (e.g. $95,000 wired to the title company at closing). This would also have 2 point prepay penalty if paid off prior to 6 months. The document prep fee and recording fees are also paid by the borrower. My typical rehab loan is only for 1 year, because the theory for private lending is to turn the money as quickly and as often as possible so as to make more money in points (some lenders even take a piece of the upside, or profit, of the borrower’s project).
      If you don’t want to service the loan yourself, you can also use a servicer like FCI Lender Services (trustfci.com).

      I hope this helps,

      Dave

  6. Hi Dave,
    I have two rental properties paid off and have a mortgage on my primary residence, I’m not working as of now (disability) I’m trying to purchase another rental property, my question is;
    should I look into borrow money from the rental properties for a down payment or pay in full price .

  7. Dave, I am going to disagree with you on taking a loan against your primary home as a good defense to being sued. In many states the bankruptcy laws and garnishment laws protect much or sometimes all of your personal residence. They can make you sell your 20 rental units that you have 20% equity in, but they often cannot make you sell your home. If you run your business in your sole name you can also put your house in joint tenants by the entireties and unless your wife is also liable on the lawsuit the entire property is protected from your creditors on debts you accrued solely in your name.
    I think using your home equity to grow your business can accelerate your buying more properties, but most states protect your home above nearly every other type of asset.

    • Dave Van Horn

      Hi Jerry W,
      I agree with you that Bankruptcy laws and garnishment laws can protect your primary residence in some cases. However, I have a close relative, whose restaurant went bankrupt, and he and his wife had personally signed the commercial loan for the restaurant. The bankruptcy court ruled that if there was more than $50,000 in equity in the property (their primary residence), they would have to liquidate it. Luckily for my relative, we were in a down market, so the appraisal came in lower than normal. In this case, he was able to keep is primary residence, but it was absolutely at risk. If he had separated the equity from the property and placed it in a safer vehicle, the property’s equity wouldn’t have been at risk at all.
      Best,
      Dave

      • This depends on state law. In a state without strong homestead protection laws, creditors can come after one’s personal residence. In other states, an exemption is provided up to a dollar value.

  8. Hello Dave,

    I realize this thread is dated but hoping you’ll see this. I have a rental property with about 40k equity, and a primary residence with about 60k equity. I also have credit cards and self directed IRAs. I would like to consider purchasing an additional rental property. Where would you pull money from for a down payment? Thank you

  9. Jeremiah Miller

    Hello Dave, thank you for this article. I’m new to property investment and am trying to learn about financing to purchase my first investment property. I’ve had a difficult time trying to understand how a person repays the home equity loan or HELOC. If I would use this type of financing would that create another large monthly bill (assuming approximately $1,000 a month) in addition to my current mortgage on my home, or would the mortgage on my home be extended or require a higher monthly payment? If someone could answer this I would very much appreciate it. Thanks.

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