3 Risks and Drawbacks of Using Home Equity When Investing

by | BiggerPockets.com

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.

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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.]

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

Leave your comments below!

About Author

Brandon Turner

Brandon Turner (G+ | Twitter) spends a lot of time on BiggerPockets.com. Like... seriously... a lot. Oh, and he is also an active real estate investor, entrepreneur, traveler, third-person speaker, husband, and author of "The Book on Investing in Real Estate with No (and Low) Money Down", and "The Book on Rental Property Investing" which you should probably read if you want to do more deals.

12 Comments

  1. Paul Merriwether

    Jessica’s 2% cap going to 24% is a real STRETCH!!! That would take 12 yr’s, however I’ve never heard of an adjustable loan that didn’t have a cap on overall rate increase like you mentioned yours being 11%. So why mention a scenario that isn’t relevant?

    What is more relevant is the fact the $18,000 was equity that could have disappeared within hours if a storm or other disaster had happened to that property eliminating equity. Taking that $18,000 out reduced the risk of losing it over time. She also benefited from the fact that leverage was now working for her. The $18,000 in her home was not being used, yet in this new purchase it generate cash flow and her cost was only $60/mth. That’s $60 to what ever positive she now had. That’s a win/win in anyone’s book at very low risk!!! Equity lines can be eliminated at any time by a bank. The positives far out way the negatives for an investor seeking to capitalize on a fast moving investment.

    A good friend borrowed every single penny out of several HELOC before the 2008 crash and just before banks started shutting down those lines. Money in hand is far better than equity locked up!!!

    • Sami Senoussi

      My though exactly! I feel like most biggerpockets writers as well as members are heavily biased toward cash and therefore aren’t very knowledgeable when it comes to financing.

      If you’re going to Include your loan possibly shooting up to 24% in your “worst case scenario”, you may as well start start researching the extent of your liability in tenants spontaneous combustion or meteorite obliteration.

  2. Jerry W.

    Brandon,
    Very good advice. All of my loans are ARMs, with a 5 year adjustment schedule 5 Year ARM. While I could handle a rate increase of the 2% on any loan easily, if every loan in my portfolio got a rate increase like that it would hurt. You should always consider the worst case scenario.

  3. Brian Smith

    I used a line of credit to purchase my last three houses. I find a great deal, fix (clean) it up and then ask my bank for a loan on the property. When the appraisal comes in it will be high enough to cover 100% of my investment. The bank will loan 80% of the appraised value which is enough to cover 100% of my investment because I bought it well enough below market value. I get my initial investment back and repeat.

  4. Hi,

    Thank you for sharing information about Risks and Drawbacks of Using Home Equity When Investing. Actualyy i dont about risks and draw backs of usinmg home equity when investins. Now I got information about that. It is very useful to all the people. Please every one should read this.

  5. Eric Jones

    Good points – especially the point about over-leveraging.

    In terms of interest rate risk, I agree that obviously rising rates can result in increased payments after the lock period. But that alone doesn’t give a good indicator of risk because interest rates, especially mortgage rates, are primarily driven by inflation expectations. So if your HELOC or ARM is currently at 4% and adjusts up to 6%, that implies a 2% increase in inflation. But for REI investors this inflation is great news because it means the economy is very strong and GDP is growing around 4% per year… which means your leveraged asset is now going up in value by 2%. You can also presumably raise rents another 2% to keep up with inflation. So yes, interest rate risk is a real thing, but it’s important to not look at interest rates in a vacuum. Frankly, I’d love it if we see 4% growth and a 2% net increase in inflation, but I doubt we will see it in our lifetime!

  6. Mike Dymski

    I like HELOCs (used properly) for liquidity, flexibility, their low cost, additional asset protection (2nd recorded mortgage) and to mitigate risk. Having quick access to liquid funds provides a lot of flexibility for a real estate investor plus it mitigates risk by providing liquidity for unexpected events (job loss, economic downturn, excess vacancy, excess cap ex, etc.). Many HELOC products now have HEloan conversion features that allow you to convert to a fixed rate amortizing loan should you plan to be into the HELOC for a longer period. Good tool, if used wisely, as mentioned in your article. Thanks for writing.

  7. Terrell Garren

    Certainly not for everyone, but I used a Home Equity loan around 8 times over the past 20 years to buy rental property. The interest rates were low (e.g. 3% or so and fixed rate). I never felt like I was putting my home at risk since worst case I would cash in my 401K to save my house. The process has allowed me to react quickly to good investments of 10 plus single family rentals. 2008 through 2012 was like shooting fish in a bucket.

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