Hello, my friends and welcome to another episode of Ask Marco where I answer your investing related questions.
Today’s question comes from Jonathan and he says: “Hi Marco. I’ve been enjoying your podcast for a few months now. Answers from a professional to questions, many have has been quite educational and you are welcome. My question involves analyzing the risk-reward of a cash-out refinance to utilize a portion of the equity from our primary residence to hopefully launch into real estate investing. My wife and I have lived in this home in Oregon for the past 10 years. Current equity is about $200,000 but recently tied this to a HELOC for $46,000 which was used to remodel a large portion of our home. We are both around the age of 50 and have been paying into 401k’s from our W2 jobs but do not have a longterm investment strategy beyond that, single-family homes or small multi-units would be of interest and not necessarily in our current market with a structured goal to scale over time. Thank you for your time! ~Jonathan.”
Thanks for the question. Jonathan. This is a good one and if you haven’t seen or heard the episode that I released just recently, I believe it was number 224 titled $700,000 Equity to Invest – A “Live” Client Call. I went into this in a fair amount of detail on that call, but that was a live call that I had recorded. So I’m going to answer your question and give you the bullet points and I actually suggest you listen to that episode. But I will give you a good overview right now just to compare and contrast what you might call the risk versus the reward. And I’ve talked about this on and off over the years on other episodes. Just touching upon it and diving into some of the detail here and there, but I’ll just kind of paint a very simple hypothetical example here using round numbers.
Just to give you the answer to your question about the risk and reward. I guess let’s look at this as two phases. In phase one you’re going to have a hilar, a home equity line of credit and there’s a cost in using that equity. You don’t actually pay anything until you draw from that line of credit, but once you do, you’re paying typically an interest-only monthly payment, but what you need to consider is what is the gain in using that equity for investment purposes. In other words, if you can unlock that dead dormant or idle equity that you have in your principal property or for that matter any property, it doesn’t have to be your principle residence. If you can take that equity and turn it into liquid investible capital and turn that into income-producing assets that produce more in terms of cash flow than the cost of using that equity.
Then what you’ve done is you’ve arbitraged the cost of using that equity in the form of a HELOC against the gains you’re going to receive from your new investments, your new rental portfolio or whatever that might be. So let me give you an example here. We’re going to make a couple of assumptions. First of all, the average interest rate as of today on a home equity line of credit is 4.75% so if you, let’s say, tap into $100,000 of your idle equity in your property and turn that $100,000 all of it into a used line of credit. So you’re pulling out $100,000 through the hilar, you’re looking at an interest-only payment of $4,750 per year. Divide that by 12 it’s roughly about a $400 per month interest payment. It’s actually $394 in change. But let’s call it $400 a month on the hundred thousand dollars of liquidated equity from your property.
Now let’s also make an assumption that you are going to take that a hundred thousand and turn that into for single-family homes of $100,000 each. You can slice and dice this different ways. You can turn it into five properties of let’s say $80,000 each or three properties of about $130,000 each, whatever the case is, let’s call it for single-family homes. Let’s also say that the net cash flow from each of those properties is $300 a month, so your total cashflow net is $1,200 per month. Positive cashflow, that’s after all expenses and debt service. Now if you take that $300 per month per property and subtract the $100 per month per property from your HELOC interest payment, you’re left with about $200 per month per property. Multiply that times the four properties you just added to your portfolio. You’re looking at $800 per month, positive cashflow, true net spendable dollars in your pocket.
Although I don’t suggest you go and blow that on. Do dads or consumer items, ofcourse you want to save that for future investments. Save it for the sake of savings, save it to put towards additional investment property, whatever the case is. You can see right here that your gain far outweighs your quote-unquote cost on the use of that equity in terms of the interest payments you’re making on it through that home equity line of credit. Now it gets better than that, so if there was nothing more, you can see that you have essentially arbitrage the cost of that borrowed capital against the gains that you have on additional property or other investments. But let’s look at a few things here. One, you have now four new properties with four new mortgages and as those loans on those four properties are being amortized because you have a tenant in place and that monthly rental income, a portion of that goes towards the principal and interest payment on the property.
Well as you amortize the loan on those properties, what you’re doing is in that first year, and this gets better as time goes on, but in that first year you are paying down approximately $100 per month in ammortization. So if you just compare that one item to the interest payment on your home equity line of credit, it’s about a wash. you’ve got about a hundred dollars a month in interest versus the hundred dollars per month in gains in equity gains in your properties because of the loan amortization. So you’ve got $100 gain and a $100 interest costs. They’re about the same and it’s essentially a wash. So you’ve got that going on plus the positive cash flow. Now let’s take this one step further. You’ve got for $100,000 properties and let’s just say you have a modest 3% per year rate of appreciation that may be higher, much higher, some years it could be lower, maybe negative some years, but let’s just say over time, whether it be three years, seven years, 10 years, whatever it is, you have a modest 3% appreciation gain on each of those properties.
$100,000 property appreciating at 3% per year is $3,000 per year. If you divide that by 12 months. Just to break this down to a monthly comparison, it’s $250 per month appreciation gain per property. Again, you’re comparing, if you want to make the comparison, you’re comparing $250 per month of appreciation versus the $100 per month interest payment that you are using on that borrowed money from your home, your property through that HELOC. So the net result there, just on that one line item is $150 per month gain. So another positive factor, and I’m going to throw one more bullet point in here, let’s call it a bonus item. The bonus here is that the interest payments that you’re making on your HELOC, your line of credit might be tax-deductible. For a lot of people, it will be tax-deductible. Now, I can’t say definitively whether it is for you or not because it depends on what state you live in and to some degree what your personal tax situation is.
But this is written into the tax code. So check with your tax advisor. But for a lot of people, that’s going to be a tax deduction so that $100 per month or whatever the cost is for the borrowed money might actually be a tax-deductible item. So the true net cost, the real cost of it might be lower than a hundred dollars per month that we were talking about a few minutes ago. So that’s all phase number one. Phase two is in three years, five years, seven years from now, whatever it is, depending on the market that you’ve invested in if you’ve got a relatively predictable rate of appreciation going on and the equity in those properties is growing and growing for two reasons. One through the appreciation and two through the amortization of the loan, just giving you additional equity. What will happen is at some point in time you’ll have enough equity in there to refinance one or more of those properties and pull that equity, that new equity out.
And what do you do with it? Well, you can one pay off some or all of the home equity line of credit that you started with on your principal residence here and or two, you acquire additional rental properties to add to your portfolio and start to grow or mushroom the size of your rental portfolio. So this starts to snowball on itself every three to five to seven years. Again, depending on what type of market you’re in. So this strategy is pretty simple yet very powerful. And if you understand this, you will see that you can accomplish a lot. In a relatively short period of time. A lot of people can build a sizeable portfolio in 10 years or less. Knowing where to invest in having the right strategy. And that kind of segues into the whole concept of talking to some trusted advisor. And if you don’t have one, feel free to contact one of our senior investment counselors here because they can walk you through this in a little more detail and also a little more applicable to your personal situation, wherever that maybe today.
So I hope that helps. And I think not only you, Jonathan, but a lot of people probably have this question in mind or they should be asking themselves the same question and not realizing that they could be asking this question or, or looking at their personal situation the same way because they have the equity, but they’re not thinking the question of what can I do with that equity or can I even tap into that equity in the first place. So when you analyze the risk-reward of a cash-out refinance, whether it be on your own principal residence or any of the rental properties or any real estate for that matter that you have, you can start to see a benefit in applying it the right way. Anyway, I hope that helps and I appreciate the question and for everyone else listening, if you have another question like this or anything completely different, just click Ask Marco at passiverealestateinvesting.com you can also go to AskMarco.com and submit your question and I will try to cover it here on the show. Remember to subscribe. Thanks for listening. I will see you on our next episode.
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