How to Use a HELOC on Investment Property
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Summary:
If you own a home, you can utilize a HELOC, or home equity line of credit, to build an investment property portfolio. Before you take one out, you will have to run some numbers to make sure that your return on investment will exceed the interest rate you pay on the HELOC, especially since the rates are variable.
Have you ever seen those YouTube advertisements by so-called influencers that tell you they have the secret to building wealth? Something along the lines of, “I went from broke and living in my parents’ home to making $20,000 a month, no unsecured personal loan with sky-high interest rates needed!” You can tell right away that they are offering a monthly subscription service to tell you how to get rich and build wealth.
Usually, these are borderline scams. But if you own your home and are serious about building wealth, you should pay attention to the idea of using your home as leverage. If your home is worth more than you paid for it, you can tap the equity to further invest. One way to do this is by taking out a HELOC. If used correctly, this can be a brilliant tool for those looking to build an investment property portfolio. Keep reading to learn how.
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HELOC 101
HELOC stands for home equity line of credit. It acts similarly to a credit card — you have a credit line based on your home’s equity value. The lender will typically give a 10-year draw-down time to use the money and a maximum value you can withdraw from your equity during that time.
You can borrow what you need when you need it as long as it’s within the maximum borrowing limit. The interest rates charged on a HELOC are variable, so in a high-interest-rate environment, the loans will be more expensive, and vice versa in a low-interest-rate environment. This can act as a deterrent, according to Luke Michaels, an experienced residential mortgage lender.
“One of the most common deterring factors is HELOC interest rates are variable and tied to the “Prime Rate” (the FED’s base rate) — meaning much like mortgage interest rates, these fluctuate up and down based on where the interest rate market currently is,” he says.
However, be aware that because these interest rates are variable, they can also go down if interest rates go down.
Paying it back
In most cases, you will have 20 years to pay the loan back after you draw down. Below is a simple example of what would happen if you borrowed $20,000 from a HELOC at 6% interest and paid it back in 10 years.
| Year | Interest | Year | Interest |
|---|---|---|---|
| 1 | $1,200 | 6 | $7,200 |
| 2 | $2,400 | 7 | $8,400 |
| 3 | $3,600 | 8 | $9,600 |
| 4 | $4,800 | 9 | $10,800 |
| 5 | $6,000 | 10 | $12,000 |
Using HELOCs on investment property purchases
As HELOCs are like credit cards (often with a much higher credit limit), you can use them to purchase or invest in investment property. Whether you want to buy a second place in the mountains to rent on Airbnb or build an international property portfolio, a HELOC can be a powerful tool. With investment property, the primary purpose is to make money. To do so, most individuals (not large funds or corporations) will look at two factors: rental yield and capital appreciation.
Rental yield
The rental yield is the amount of income you receive from renting a property or asset in the form of a percentage.
- Thegross yield is the rental income per year divided by the price.
- The net yield is the gross income minus fees divided by the price.
Capital appreciation
Capital appreciation is the increase in the value of the property, which also increases the value of the equity you have in the property. Effectively, you are betting that the property will be worth more than you paid for it, increasing the overall ROI. You can see how both of these terms operate in our examples below.
Investment property examples
The main variable when you consider a HELOC for investment property is the interest rate. Herein lies the secret to mitigating risk and successfully using a HELOC to invest in property; the ROI must beat the overall cost of the debt from a HELOC.
If you are looking at buying property in the U.S., then you need to note that unless you pay cash, the interest rate on the new mortgage will be based on the interest rate environment, just like your HELOC. In a high-interest-rate environment, you will pay high-interest rates on both your HELOC and your new mortgage, and vice versa in a lower one.
One solution to this would be to diversify out of the country. To make it simple, let’s model out some scenarios. We will look at buying an investment property with a HELOC in two different places. We will fix the interest rate on the HELOC at 6% and have a three-year exit strategy.
Example 1: Denver property
In the first example, Mr. Wang wants to buy a second property in Denver, Colorado. He has a home worth $500,000, in which he has a HELOC for 80% of his home’s value, or $400,000. He wants to buy a new home in an up-and-coming area and sell it in three years. Let’s take a look at the numbers. He wants a long-term renter, which will actually run at a loss for him, but he hopes the property will increase in value.
| New home price | $600,000 |
| Needed for 30% down payment | $180,000 |
| Value in 3 years | $700,000 |
| Mortgage (70% after down payment) | $420,000 |
| Borrowed from HELOC | $180,000 |
| Interest on HELOC | $32,400 |
| Additional costs and fees (buying & selling) | $21,000 |
| Maintenance costs (HOA fees, property tax) | $25,000 |
| Total costs | $678,400 |
| Total profit (based on $700,000 value) | $21,600 |
Mr. Wang’s investment property is valued at $600,000, and he needs a down payment of 30% or $180,000 to purchase the property. He borrows the $180,000 from his HELOC at a 6% interest rate. After three years, the value increases to $700,000, and he can now sell the property.
If Mr. Wang sells the property, he will need to pay his new mortgage and his HELOC back with interest. His rental income does not quite cover his mortgage, and this, combined with property tax and HOA fees, gives him another cost of around $25,000. Mr. Wang makes a profit of $21,600 but only because property prices went up to $700,000. If property prices only went up to $650,000 or they fell, he would be at a loss.
Example 2: San Juan Del Sur property, Nicaragua
Mr. Wang is also looking at a rental property for surfers in San Juan Del Sur, Nicaragua. He figures that all of the gringo surfers have gotten priced out of the Nicoya Peninsula in Costa Rica, and San Juan Del Sur is a cheaper option. He doesn’t see the property prices going up, but he can make good money from renting the property out for surfers, and it’s cheap to build.
| Home value | $120,000 |
| Nightly rental | $60 |
| Gross income from rental | $21,900 |
| Occupancy at 70% | $15,330 |
| Gross yield | 12.78% |
| Yearly fees & costs | $3,000 |
| Total income after fees & costs | $12,330 |
| Net yield | 10.27% |
| 3-year total net | $36,990 |
| Interest on HELOC | $21,600 |
| Total profit | $15,390 |
Mr. Wang assumes the value will pretty much stay the same and that the play here is the high yield. Assuming that his place is rented out 70% of the time and accounting for the various fees involved in maintaining the property, he will make a net income of $15,390 after three years accounting for the interest he is paying on his HELOC.
An important factor to note is the yield vs. the HELOC interest rate. As long as your net yield percentage is significantly greater than your HELOC interest rate, you stand to make a profit. If your HELOC rate goes up, the cost of debt can make the cash flow on your rental property negative. If your rate goes down, then your ROI from each year renting the property goes up.
Pro Tip
Do some research and make sure you can rent out the property before you buy. The debt you take out is guaranteed, but the ability to rent out the place is not.
Requirements for a HELOC
HELOCs are not given out willy-nilly; they are tougher to qualify for than other home loans. Typically you will need the following:
- A great credit score (620+ but 720+ is usually preferred)
- A great credit history with banks, credit unions, credit cards, personal loans, and more
- Debt-to-income ratio of less than 50%
- Equity of 15-20%
Ready to take the leap? Compare your options for a home equity line of credit.
What about HELOCs on multiple investment properties?
You can technically get a HELOC on an investment property you already own. For instance, Mr. Wang could get a HELOC on his new property in the U.S. if he maxes out his primary residence HELOC and there is enough equity built up in his new property that it makes sense. However, be aware that investment property HELOC requirements are even stricter on an existing investment property vs. a primary residence.
These are typically as follows:
- 720/730+ credit score
- Debt-to-income ratio of less than 43%
- Equity of at least 20% after HELOC
- Cash reserves enough to pay at least six months of costs
If you are at the stage where you have multiple HELOCs on multiple properties, you must have a pretty big property portfolio, or you are maxing them out on some other investment. Either way, if you are at this level, it’s best to have an accountant and an advisor to help assist.
FAQ
What is the difference between a HELOC and a home equity loan?
Home equity loans are like a second mortgage; you borrow the equity from your home with another loan. It will come in a one-time, lump sum payment. The one-time lump sum payment is similar to a cash-out refinance. A HELOC is based on the equity of your home but acts s a revolving credit line. You are only responsible for the interest during the draw period and can draw down as much as you like from the line of credit.
The interest rates can also differ. You have the option of fixing a cash-out refinance or a home equity loan interest rate, but HELOC rates are always variable. This can actually be a plus in a high-interest-rate environment in which fixed rates will be on the high end. Michael Bardales, the owner of Radius Mortgages, likes to recommend HELOCs in this scenario. “Options such as a rate and term refinance or a home equity loan are likely to lock you into a high-interest rate, making a HELOC a better choice for many borrowers as long as the rate will remain variable throughout the agreement term,” he says.
Options such as a rate and term refinance or a home equity loan are likely to lock you into a high-interest rate, making a HELOC a better choice for many borrowers as long as the rate will remain variable. - Michael BardalesClick to Tweet
Should you use a HELOC to invest in stocks?
Just like building a property portfolio, the return on your investment should be greater than the cost of debt for your HELOC. You can use a HELOC to purchase stocks, but you need to make sure that the performance of the stock will exceed the interest you’re paying.
Should I pay off my HELOC or invest?
You should always pay off your HELOC under the terms of the agreement. Any missed HELOC payments could have a detrimental effect on your credit score. You can both pay off your HELOC and invest. If you have multiple rental properties, the income should be enough to pay off your HELOC as long as the net yield is greater than the cost of the debt.
How much money can you take from a HELOC?
That depends on where you get the money. On a primary residence HELOC, which most of our readers will probably be using, you can borrow up to 80% of the value of the home. If it’s an investment property, you can borrow 80% of the value of the home’s equity, with at least 20% equity left in the property. Then you can use as much of that money as you need.
Key takeaways
- HELOCs are revolving lines of credit with variable interest rates based on the value and equity of a home.
- Generally, when investing in property, people make money from rental income and value appreciation. The ROI must be greater than the cost of the HELOC for this to make sense.
- HELOCs are more difficult to get than your standard loans. Furthermore, HELOCs on investment properties rather than primary residences are even more difficult to obtain.
- HELOCs can be used for other investments, such as building an investment property portfolio. However, the numbers need to make sense.
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