Hello, my friends and welcome to another episode of Ask Marco where I answer your investing related questions.
Today’s question is a great one. It’s from Kelly. It’s basically should I use a heat lock for my down payment and she writes in and says, hi, Marco. I just would like to start with how amazing your podcast is and you have really helped me outline a plan for financial freedom while Kelly, you’re welcome. I just purchased a home that I live in and I’m interested in using a HELOC to purchase a rental property. This seems risky to use my home like this but would love your thoughts
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Okay, so for those listening and are wondering what HELOC is, I think many of you understand what he lock is, but for those that don’t, a HELOC is a home equity line of credit. So it’s just the acronym for home equity line of credit and it’s really just a loan.
Actually, it’s not even a loan. It’s a line that you can draw from that is secured by your home. Typically it’s recorded as a second or third lien on your property and you draw from it just like you would a credit card. Uh, you don’t pay any interest on it while you have it until you actually use it. And typically these are issued for a term of 10 years and after that, you have to renew it or it just closes. So the HELOC is interesting because it’s typically a line of credit that you can draw from any time at will for as much as you want. You use it and whatever you don’t use, you don’t pay for, it’s typically a very low-interest rate and it’s just secured by your property, which is the reason why you can get them for such a low rate of interest.
And in addition to that, the terms are typically interest only. So you can draw out say $1,000 or $20,000 or whatever it is up to your limit and just pay the interest-only payment each and every month until you pay it off in whole or in part with no penalty. So it provides for a ton of flexibility. And for those of you that this actually makes sense for, you should look into it because if you have enough equity in your home or even in a second home or a rental property, there are lenders out there willing and wanting to provide these lines of credit that you can use for anything. They could be used for a home, improvements for investments, they can be used for travel. Although you know the the whole idea of using a HELOC for consumer debt is really pretty stupid. I wouldn’t use it for anything that is considered consumer expenses or in consumer debt.
So using it for a vacation or a car or anything that’s a depreciating asset is pretty silly. But for investment purposes, it can make a lot of sense because there’s a lot of people out there, particularly in coastal markets that have a lot of equity tied up in their property or properties, and you can call that equity dormant, dead idle, but whatever you call it, it’s not doing you any good. It’s sure it’s on your personal balance sheet. It’s part of your net worth. That’s fantastic. But now the question is, is how can I put that to work to increase my wealth, maybe increase my cash flow and do more good for me and my family. So that’s the gist of this question from Kelly. And here’s what I have to say about that. Well, I’ve already told you half of it and you know, that’s basically how it works.
Currently, HELOC rates range between a low of about 2.9% to as high as 21% if you have decent credit, you’re not going to be anywhere near that. But it does depend on the borrower’s creditworthiness and obviously some other factors. But as of this recording, the average HELOC rate is about 6% just right around 6% so very inexpensive rate for a line of credit that you can draw from at will for whatever you need. Now let’s take an example. I always love using the example of the a hundred thousand dollars property. So if you are purchasing or investing in a $100,000 rental property, getting an 80% loan and you need a 20% down payment, then you would just draw from your line of credit for $20,000 and let’s just do the math. Let’s just say it’s 6% interest only. That’s $1,200 per year or $100 per month in debt service.
That means in addition to the mortgage, the first mortgage you have on your rental property, you have an additional mortgage payment and it’s actually a, not a mortgage payment, the line of credit, but you have additional payment for debt service of $100 per month. So if that property has a net $300 per month positive cash flow, you now are down to $200 but what have you done? You’ve actually reduced not only your cash flow but reduced or eliminated in this case your down payment. So what is your return on your investment if your down payment is zero, in other words, you’re financing 100% of that investment. 80% with the first loan, 20% with the HELOC, a hundred percent financing. Essentially your rate of return is infinite. It’s infinite. If you put zero down, your rate of return is infinity. So you are essentially getting free money because the property’s paying 100% of the debt service.
So this sounds great and keep in mind that it is phenomenal when you can do it and do it right and it works out in your favor. Just some people are a little reckless and dangerous when it comes to credit and they don’t know how to properly do this or strategize so that they minimize or eliminate their risk in doing this. And I’ll get into that in a second here. So the key thing with this strategy is you want to look at when and how you’re going to return the principle. Because remember, if you’re drawing $20,000 from your home equity line of credit, the question you need to be asking is when am I going to be able to repay that principle? Well, if you were trying to amortize that loan, like a normal mortgage would over a course of 15 or 30 years, you could do it.
Your monthly payment would be higher than a hundred dollars because now you’re amortizing the principle in order to repay it in full over the period of whatever you set out to repay it on and that would cut into all of your cashflows essentially plus or minus. You might have some cashflow leftover every month, but it would be very, very small, but that would not be the best way to go about this strategy. The best way to go about this strategy is to avoid the mistake that some investors make and that is focusing on properties that are in very, very stable or flat cash flow markets. The cashflow is great, but now you need to look at the return of paying off that $20,000 or whatever it was you drew for that down payment. And the way to do that is you need to be in growing markets. You need to do your homework and pick a strategy where you are in a growth market that has lots of momentum and is expected or projected to continue to grow in terms of price appreciation for at least the next five years.
And I know that is a little bit of a crystal ball question and difficult to do, especially beyond two to three years. It gets harder, but it is doable. It can be done. And with a little bit of our help, we can also help you do that. So let’s make an assumption here. Let’s, let’s just say we want to have that $20,000 you drew from your HELOC repaid in five years or less. Here’s essentially how this would unfold. And I, again, I’m just drawing this out, big picture, but hypothetically speaking, if you were in a market that’s appreciating on average 3% per year, and that’s pretty consistent and let’s just say that it actually happened that way, that $100,000 property appreciating 3% per year consistently over a period of let’s say 6.1 years would be enough for you to refinance that property in 6.1 years.
Pull that $20,000 back out of the property through that refinance and pay off in full the HELOC the home equity line of credit. So that’s at 3% a market or a sub-market or the location where your property is located. But what if it was 4% if you do the math on $100,000 property, 4% per year compounded each year, and again, we’re assuming that is being compounded on a consistent basis, you’d be able to refinance and pull the $20,000 out to repay that $20,000 down payment from your Hilakos in just under five years. Now if you’re in a market that is at 5% annual appreciation average, you’ll be able to do that in just under four years. It’s three-point, I think it was 3.9, 3.8 years. So it’s doable and that really should be where you set your sights so you can get into that property today, own and control 100% of that property today with zero down using your HELOC in a growth market and be able to repay that HELOC down the road, let’s say four or five years down the road.
If you’re in a market that’s appreciating four to 5% per year on average, and sometimes it’ll happen quicker. Uh, I’ve seen this happen in two and a half years and sometimes it’ll take six years or more. It just really depends on the local market that you’re investing in. This is why it’s good to have some guidance and some help. That’s essentially the strategy and the way to make a hillock work and actually have it make sense financially. Make sense? So that’s a smart way to tap into your equity. Now there’s one last comment I’m going to make for Kelly and for everybody listening to this and that is lender rules. Many lenders, and often when you’re getting conventional mortgage financing, lenders will have rules in place or overlays where they can restrict or prohibit issuing a mortgage loan, the first mortgage for your investment.
If you’re borrowing the down payment, a lot of times they’ll want to see that you actually have those funds in the form of cash, not credit and that it’s seasoned, meaning that you have had it for a certain period of time. It could be two months, three months, six months in an account or in a savings account or from some source that you have had control over it. Sometimes it can even be gift funds. It just depends on the lender. But the point here is that many lenders will not allow you to borrow the down payment because they don’t want you to be 100% leveraged in a 100% financed in the property because they see that as being a risk factor because you have little to no skin in the game. So talk to your mortgage broker or your lender and find out if that is an issue.
And if it isn’t, then great. You’ve got a new strategy open to you in terms of what capital you can tap into. Uh, in this case, it’s in the form of equity. So I hope that helps. Kelly, I know you had an additional question here. Should I put my home under an LLC first because you were concerned about the risk that this may carry? I know why you’re asking that question. Having your home in an LLC does not change anything. Your mortgage note and terms under that mortgage do not change regardless of whether you hold title in your name or you put it into a trust or an LLC. Uh, it doesn’t change anything. The contracts and agreements you have in place with your lenders are still intact and it doesn’t do anything for you. So you’re not reducing the quote-unquote risk. It’s really just having the right strategy. That’s it. So there’s no additional protection. All right. I hope I have answered that. And I know that a lot of people have been wondering about how to tap into equity. There are other ways. The 10 31 exchange is actually a better way to go, but if this is on your principal residence, you’re not doing a 10 31 exchange. So it’s not applicable, but a HELOC can be.
So anyway, that’s it for now. If you have any other questions about real estate investing, finance, whatever it may be, and you’d like me to answer it on the show, go to passiverealestateinvesting.com and just click Ask Marco and submit that. And I’m starting to batch record these here. So you’re going to see a lot more coming out here very shortly, but if you haven’t already subscribed to the show, remember to do so. Help us share this show with other likeminded people. Visit us on iTunes, leave us a rating review. Thanks for listening and we will see you on our next episode.
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