HELOC or Refinance, which to choose?

[Mitzmichael Sumilang]

I'm trying to research the best way to go about this. I went on lendingtree.com to get some refinance quotes, and now my phone won't stop ringing. My question to you fine folks is, what is the pros and cons of going with a Home Equity Line of Credit as opposed to Refinancing my investment property? I'm looking to purchase a multi family right now and use an FHA loan to house hack the property and live in one of the units. I'll live in the property for a year then move onto the next property with another FHA loan and try to build my personal portfolio. It's my understanding that a refinance will have considerably more closing costs than a HELOC, but a HELOC will have a higher rate. Just trying to get a better understanding of which route would be best.

[Albert Bui]

Advantages of HELOC is the that interest is calculated based on simple interest on a daily schedule (rate/365) and each day is calculated individual from the other so payments have a more profound affect to reducing your balance especially if you pay your loan frequently and use your HELOC as a checking account.

The downsides of the HELOC is that the rate is typically monthly variable which just means if the fed adjusts the fed funds rate then prime typically follows (prime usually .25% higher than fed funds) and can change the next month.

The good part with commercial LOC (lines of credit) is they can usually be obtained at 5 year fixed rates interest only and differ from residential HELOC (home equity Lines of Credit) that adjust monthly or with a higher frequency.

A regular refinance gives you certainty since its a term loan like 30 year fixed or 30 year Amortization and 5-15 year terms (portfolio financing). The pro's is its predictable but the downside is the interest is typically calculated month to month so any early payment or payments prior to the start of the new month (usually the 1st of the next month) do not lower your daily interest cost. This causes you to pay compound interest at the expense of your peace of mind. Consequently, this period of time in between calculations makes the amortizing or pay down of principal to slow down since the payment is fixed typically and there is 30 days from month to month where the interest is recalculated. This interest calculation method results in a very slow pay down of your balance and why your average 30 year amortized loans end up only about 20% lower relative to your starting balance after 10 years of payments (assumes borrower makes just the min payment for 10 years straight).

I work with a lot  of refinance and new purchase clients and when they say they got their loan 10 years ago at X rate their balances typically are 20% lower than what they started at 10 years earlier.

The daily calculation or simple interest calculation on LOC's and HELOC's make it so that when you pay your payment it lower's your balance immediately and tomorrow's portion of interest (rate/365) is applied to the new lower balance right away instead of waiting till the next month start date.

This allows your payments to chip away at your principal balance faster even if you pay once per month but, obviously to exponentially speed it up you can use your LOC/HELOC as a checking account to park all your short term savings or make multiple payments per month. This is strategy is the one you'll see guys like Clayton Morris from Memphis invest talk about on his youtube channel. There are also other prominent investors and finance people who talk about this on how to payoff your mortgage in 5-7 years instead of 30 as an example. Its definitely possible and this strategy takes the "focus," from rate and getting the lowest rate to how much the interest is calculated or the "volume of interest." The strategy can work with higher rates too so much so that a higher rate while utilizing this strategy could pay substantially less interest than a comparable fixed rate mortgage loan with a so called "lowest rate."

This is why I ask my clients if they want the lowest rate or the lowest cost of financing their home? 

Typically its one of those questions that make people think and challenges our beliefs that lower rate is best, because its not always.

Hope that helps on your thought process on things.