SFR is paid off - Should we take line of credit for next home?

Question

We are fortunate to own a single family rental home in our area outright. The mortgage loan was paid off earlier this year and now we are seeing higher monthly cash flow. The home value has appreciated considerably. We bought it for $155K in 2002. Our 2018 tax assessment was $300K. It is in a great location which has kept vacancy super low in the past 9 years we have rented it. We want to keep the property as a cash flowing rental.

We are interested in investing in another cash flowing rental property this year to BRRR. We are open to properties in our local area (Anchorage, AK), or Denver or Las Vegas because we have some personal connections in those areas.

Here is my question:

Should we take out a HELOC (home equity line of credit) or a home equity loan on our existing SFR home (that is paid off) to finance a 10% down payment on the new investment's mortgage? Estimating we would need $20K to $30K for a $200K - $300K property.

OR

Should we keep this SFR home paid off to maximize its cash flow and use other sources of financing (personal savings or piggy back a home equity loan on a conventional 30 year mortgage loan) to finance the down payment on the new investment?

Pros for NOT taking line of credit; keeping home fully paid off: We worked hard to pay this rental home off the past 10 years and it is finally cash flowing nicely. Lower financial risk if we had a longer vacancy or costly repairs because the rental expenses are lower. Peace of mind from less debt.

Pros for taking out the line of credit: We could capitalize on the SFH's equity (while still keeping it as a cash flowing rental- although the high monthly cash flow would decrease - and avoid "parking our money" in the home's equity. In this scenario, we are leveraging OPM "other people's money" to invest with a 9:1 accelerator. Seems the downside is that we would reduce our equity and monthly cash flow. We would assume more financial risk if there is vacancy or costly repairs because higher rental expenses rather than keeping it paid off. Less peace of mind due to increased debt, but trade off is better use of OPM.

I will say we are leaning to taking out the line of credit for the pros mentioned above, but excited to hear your perspectives. This BP community is awesome to share ideas/experience.

Cynthia Oistad · Answer

@Jamie Rose, that would be great! Message me your contact info and I’ll send you what we are looking for! Would like to get set up for automatic emails that meet our criteria. Thanks to everyone for your responses!!

Cynthia Oistad · Answer

@Bill Brandt- thanks for your response and for sharing for the difference on the HELOC vs. the home equity loan! good point! I agree with you on 20% down also to avoid PMI. I am reading "Rich Dad's Real Estate Advantages" and the authors reference a $1:$9 accelerator to borrow 90% of cost of an investment and use your own money to cover the remaining 10%? I questioned that when I read that but just figured I was just not yet aware of potential opportunities out there where you can get a bank loan for 90% of the cost (and pay PMI) or maybe bring in a partner or private investor to cover the other 10% of the 20% down payment to avoid PMI? We do have approx $150K equity in our primary residence but not as much as our fully paid off rental home which has about $300K equity. I'm intrigued .....Why is the primary residence considered a cheaper source of funds?

Bill B. · Answer

@Cynthia OistadIf you go with the equity pull out you defiantly want the home equity loan no the line of credit. Equity loans have fixed rates, lines of credit have variable rates, they have no where to go but up. You’ll probably need 20 or 25% down to purchase a rental property, not 10%, that has been my experience at least. Plus you’ll avoid PMI then too. I’m currently in the paying off mortgages stage (from 10 down to 7 now) so I understand the good feelings that come with paying them off but I would just do the math on the total payment and total expenses/interest per year of each way and one should be obviously better. Do you have any equity in your primary residence? (Your cheapest source of funds.)Good luck and keep asking questions.

Account Closed · Answer

Are you able to use funds from a HELOC as a down payment for another mortgage? I know they've loosed the sources of down payments over the last several years but using debt as a down payment used to be a no-no. I think the answer to your question lies in what you really want to do? Do you want the safe return or are you wanting to risk some of what you've earned so far to get more? When faced with those situations I like to envision the worst case scenario and then ask myself if I could live with it. If so...jump. If not take the safe route. The market has been really good for a while and housing in many areas is starting get near the unaffordable level for the average family. Test the math of your plans with a few years of price reductions and/or stagnant inflation and see how it works and if you'd be OK.

Cynthia Oistad · Answer

Account Closed - thanks for your response. We have never done a HELOC or home equity loan so we are still trying to learn and figure out pros/cons of each. I think we are in a position to risk some of what we have earned to try and build wealth. We have avoided debt our whole lives, which can be a good thing in minimizing financial risk. But we are seeing the downside of debt avoidance as we are learning more on real estate investing. We were motivated to pay off our rental property mortgage that we refinanced from a 30 year loan to a 10-year loan as a way to pay it off sooner and minimize our total interest that we would have to pay. The larger monthly payments resulted in negative monthly cash flow the past 9 years. :( At the time, we thought that was a smart move to basically defer our gains/short term income in the interest of having a paid off property in 10 years. Now the house is paid off we are finally seeing good cash flow, but we also are realizing now, that instead of having had our tenants pay the additional interest on a longer loan period, we used OUR money and savings to pay down the interest. Trying to avoid a similar situation on our next Real Estate investments and interested in learning more about leveraging debt and using OPM to build wealth/portfolio. That said, our principles around debt-avoidance are not going away, but we would make sure before we take on more debt that we have enough savings in a reserve to cover the rental property expenses (on all investments) for at least a year if we had to for some reason. This is one reason we are looking to increase our rental properties and diversify which markets/states they are in so if one goes vacant or rental market drops, we have other rentals bringing in rental income to help us until we can turn it around or hold it until market recovers.

Jamie Rose · Answer

Hi Cynthia,Everyone gets to chart their own course! For our family - owning a few rental/income properties has made a tremendous difference. I would love the chance to show you some of the investments on the market and recently closed in the 2-4 unit and 5+ unit space if you're interested. I just joined my friend in his business, pursuing our passions around investment real estate (read: I got my license and am doing this full time now!). If you and/or your husband would be interested - let me know!With thanks,Jamie Rose

Anthony Wick · Answer

My goal is to have 80% loans on all my properties, hopefully at all times. I get some people need that piece of mind. My piece of mind comes from having my money work for me. You asked if you should take out 10-20% of equity for down payment. I say take out 80% and buy 4 properties! I’ll take as much money as the bank will give me at 4-6% interest, and make 15-20% gains.

Josh Engelhart · Answer

If you are looking to grow your portfolio and stay in the residential space I would definitely be an advocate for the HELOC. Origination fees are likely close to $0. Depending on the lender you can go up to 70% or 80% LTV. You don't have to use it all at once and you only pay interest on what you are using at that time. You could tap that equity for the down payment on way more than one more rental if you wanted to. You could also let each new property pay back the money you borrowed against this one to eventually pay the HELOC back down.If you are looking to really go for it and get into commercial/ apartments I would sell this and go for the 1031 as suggested by @Caleb Heimsoth. If it's really worth $300k now that could be 25% down on a $1.2MM building or complex.If you are looking for piece of mind than you probably want to stay put.Personally I think leaving all the equity in that one house is a waste. Right now you are guaranteeing low risk and low returns. You don't need to leverage everything to the max and I wouldn't recommend taking on more risk than you are comfortable with. Some think it's less risky to have moor doors because you aren't hit as hard by vacancy, can take advantage of economies of scale, etc.

Ron Fletcher · Answer

1. In one of your responses you mentioned bringing in an investor to lower down payment. Not sure if you are considering that or just saying what others do. Bad idea. You have plenty of equity to do this on your own and avoid that. 2. Don’t rush to avoid higher future interest rates as one comment alluded to. There is already concern (the yield curve flattening) that the fed may need to slow down on future increases. They may never come. 3. All things considered, pulling some equity and buying another property could be considered diversifying your portfolio which is a good thing. 4. You seem like a great saver. You will be fine with most any of your hypothetical possibilities.

Caleb Heimsoth · Answer

Cynthia Oistad a tax assessment isn’t a good way to value a property so make sure you get a CMA from a realtor or something similar to get a good idea to what value is. Secondly I would explore the option to 1031 exchange into a larger property. It never made sense to me to do what you’re basically saying. You refinanced from a 30 year to 10 year and paid it off (I wouldn’t do that but it’s not necessarily a bad thing) but now you want to refinance to basically pull your own money back out (which could cost 1-3k in closing costs) Buy rentals, have tenants pay them off for you. Once it’s paid off leave it be. Of course you’ll need a lot of rentals for this to work