Is there an advantage to using equity from my home to purchase an income property?

Question

I have close to 450k of equity in my current home, we don't own it free and clear, just put down a very large cash down payment. I spoke with a lender yesterday and he suggested I open an equity line on my house and use that as cash to purchase an income property, avoiding all of the paperwork of a second mortgage. Is this something people do?

Jon Holdman · Answer

If you do this be dang sure that you can afford the payments on the HELOC on your residence even if your rental property business is a complete bust.  You don't want to be on the street if the rental turns out to be a bad investment.

In my opinion, this is a bad idea.  Lots of folks advocate this "freeing trapped equity" approach.  Especially folks who stand to make money if you do it.  IMHO a residence is just an expensive doo-dad.  Expensive doo dads should be owned free and clear.

Albert Bui · Answer

HI Peter,

It really depends on your investing skill level and overall financial IQ with debt and investing.

Like one other commentator mentioned its also about risk tolerance but risk tolerance is relative in the sense that as you gain more experience and financial IQ you feel more confident about risk and what was considered "risky," before is now a calculated risk because your knowledge/skill has improved.

Other commentators will mention not to use your home to obtain leverage to buy other properties because you might lose it all. Its true you may lose it all if you dont know what you're doing but back to leverage Vs Risk Tolerance can be controlled if you know what you're doing to a high degree (risk cannot be curtailed 100%). There will always be some risk but much less if you buy right (good value, found equity, or forced equity RE deal) and seal your down side through a fixed loan for instance which gives you a pre determined payment and establishes your min overhead so that you can plan your cash flow and reserves accordingly.

The advice of not using your primary is far end conservative wing advice which is great for newer investors or for the people with no experience, because the likelihood is that they have a high degree of  being susceptible to losses. Its similar to Dave Ramsey advice of anti debt vs Robert Kyiosaki advice of loving debt and leveraging yourself to the hilt.

Albert Bui · Answer

HELOC's are great short term tools to acquire rehab/flip, keeping line availability as reserves for emergency, or other short term options. This may be something to consider since HELOC's are not like ARM (adjustable rate mortgages) that adjust every 6 months or 12 months (not as volatile) but rather HELOC's payment/cash outflow can be monthly variable in that the rate is determined by a fixed margin usually .75 to 2.00% + prime depending on your specific scenario.

I would not recommend carrying a large balance on a HELOC for a long period of time 10+ years. Its probably great now while prime is 3.25% (since May 2009) but it may not always be 3.25% in the future and if it rises your monthly cash out flow will be pinched either on your rental property end or your personal income end.

Its for this reason that banks look at "global cash flow," especially business banks and they talk about "debt coverage ratio," etc. They want to know how much stress you can take before you cannot pay them back any longer. Its the banks form of risk management. Maximum rates on HELOC's may vary from state to state but in general I commonly seem them max out at 18% annual APR.

I say its also only good for a short period of time depending on what is a short period for you but in my case under 10 years is short time period. Most HELOC's have a 10 year draw period where you can get money from them, pay back/off the line, and rise and repeat. Usually during the 11th year principal and interest is required to be paid  so the payment may be much higher since it contains principal in each payment along with the compounded risk of a variable rate based on prime that could go up at any moment.

A lot of HELOC's  are 30 year loans, 40 year loans, or some are even 25 year loans so make sure to check out the term because it may impact how much amortization or principal will be required to be paid when it switches to principal & interest in years 11+ compounded with the interest rate risk that can go up to 18% in most cases.

Personally if I knew I was going to have the debt from my primary outstanding for a long period of time I would use a fixed loan with a long term so that you wont have that risk of payment increases if you adamantly intend to purchase a rental. If you decide to keep a HELOC other contingency plans could be to refinance into a fixed loan at a undetermined future rate which means you'll need to be able to qualify for a loan at that time as well, opt to lock the HELOC usually for a 1-2% interest rate add or fee, have large amounts of cash reserves, etc.

Albert Bui · Answer

That rule is true Marina if you were using your HELOC for non business/investment related things such as buying cars for leisure, vacations, etc.

In most cases if you use the funds even if its over 100k and you can trace the interest expense in relation with a business or investment you undertook you can write off that interest in excess of the 100k. The rule for the 100k of debt from a HELOC is because this debt is considered home equity indebtedness. You can look it up on the IRS website, a person can write off up to 1 million in total acquisition indebtedness (debt used to purchase or rehab a primary or second home) and up to 100k of home equity indebtedness (debt opened after 90 days of acquistion of a primary or second home).

I've worked on many case studies with accountants but your situation may vary so its always good to check with a tax professional.

Bob E. · Answer

Aly NA Sounds like you are ready to find a portfolio lender.

Aly W. · Answer

Hi @Bob Estler , we did find a local one in Florida for cash out refi's and new purchases. It did take a while, though. Rental condos in FL are still a touchy subject for lenders.

Pawan W. · Answer

@Peter Stanford you are in an excellent position to leverage your equity, I am trying to do this myself.

You do have the option to leverage your HELOC and buying cash down at 70-75% of ARV, turning it around and getting the property financed within 6 months (not considered cash out in this case).

This would ensure that you have a fixed rate mortgage and you get all your money out. If you do this 1 property at a time, you can pretty much maintain a near zero balance on your HELOC and still be positive cash flow!

Aly W. · Answer

We've used 5 Helocs to purchase additional rental properties, including one that was on our primary residence. That Heloc was paid off 5 years later during a refi.

The subsequent Helocs bought the subsequent properties. We bought them at the bottom of the bust, and the rental income has more than supported the payments. One Heloc is P&I, the rest are interest only for 10 years. Yes, the rates can change, but for now, they have been the best deal for purchasing additional properties, which all cash flow well. It's too bad we've hit our limit on the number of them. Cash out refi's are much more expensive.

As others have said, it's a matter of risk tolerance. Some people couldn't sleep if their home was on the line for an investment property. Others see opportunity and if well managed, can do very well. I'm with @Ali Boone on this one.

Marina Wong · Answer

I like the idea of using HELOC to buy something cash and then rehab. That's how you can out bid your competitors.

I have the impression that only the interest on the first $100K of HELOC can claim tax deduction. No one says anything about this so I wonder if I am incorrect on this.

Mark Bookhagen · Answer

@Joshua Springer is dead-on. I would follow his advice.

Is there an advantage to using equity from my home to purchase an income property?

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