Grow Your Net Worth Using Home Equity
Over the past few years, home values have sky-rocketed, leaving many home owners with a strong balance sheet. It's one thing to have equity on a piece of paper - it's another thing to put it to use.
Most of us have been trained to think about investing our money in terms of the available dollars we have been disciplined enough to save...that is the dollars we can see. But what if investing your money isn't limited to the cash in your bank account? This article analyzes home equity, a tool known as a HELOC, as well as an example of how to utilize HELOC in a real estate investment.
Note: I am not a financial advisor, so if you have hesitations implementing what is covered in this post, I would recommend consulting yours first. These are simply my opinions and for education purposes only.
What is Home Equity?
The equity in your home can be broken down very simply. Let's say the fair market value of your home, after an appraisal is conducted, is $500,000. Now consider the outstanding mortgage balance you owe. We'll say it's $300,000. The equity in your home is $200,000 ($500K - $300K). Simple enough, right?
That's an exciting number to see on your balance sheet, which adds to your net worth! But what good is it sitting stagnant? Wouldn't it make sense to put that to use in another investment? After all, as the market appreciates (which has historically been the case), you're still gaining all the upside.
Using a HELOC
A Home Equity Line of Credit is an efficient way to tap into said equity. The way a HELOC works is by having a bank or credit union evaluate your current home equity position. Based on the amount, your bank or CU will lend anywhere from 60-90% of that amount via a line of credit. So, using our $200K example, you may be able to get a line of credit up to $180,000. Keep in mind, every lender will have their own underwriting guidelines. As a rule of thumb, the bigger percentage of equity you borrow, the higher the interest rate will be.
The beauty of a line of credit is that only when you withdraw money will payments become due. It works just like a credit card. To sweeten the deal, your payments will be interest-only, meaning it is not required to pay down the principal amount. This will keep your payments lower.
Interest rates on HELOC's go off of something known as the Prime Rate, which is a fancy term for the rate banks charge their most credit-worthy, commercial borrowers. This Prime rate will be floating (vs. fixed) and can fluctuate month to month. At the time of writing this, the Prime rate is about 5.5% - much higher than it was even a few months ago due to rising interest rates. On my personal HELOC, the payments are "Prime plus 1". So I would actually be paying 6.5% as it stands today.
Some people may think 6.5% is high, but I would challenge that by asking: "compared to what?" Keep in mind, historically speaking, that a 6.5% interest rate is quite reasonable. We've been in an unusually low interest rate environment since Covid, and now they are normalizing. Another point to make is in regards to opportunity cost and arbitrage. Arbitrage means we are borrowing at a certain interest rate in one place to reinvest the money at a higher interest rate somewhere else. If we can go get an 8% return in a Multifamily syndication deal, there's 1.5% arbitrage....but that's just the start.
By the Numbers
Let's say you decide to invest $100,000 from your HELOC into a real estate syndication. A reasonable return to expect might be around 7% over a 5 year timeline. At those assumptions, distributions would end up paying, on average, a monthly amount of $583. Over the full 5 year hold, a total of $35,000 in distributions would be paid out.
Don't forget we have a HELOC payment along the way. If, as part of your HELOC terms, you are paying an average of 6.5% interest, this ends up being a monthly payment of $541. Over the 5 year hold, you would owe $32,500 in HELOC dues. Your profit on the investment distributions would net you a whopping $2,500 across 5 years....don't get too excited, now ;)
But in reality, we have to zoom out and look at the bigger picture. If you're familiar with syndications or real estate investing in general, you know that cashflow distributions are just one of many benefits. Remember, you are an equity partner in this syndication, which means you are participating in the proceeds of the property's sale or refinance. It is not uncommon to 2x your money during the 5-year hold period in a Multifamily deal. So with this in mind, in addition to the $35,000 in distributions, you could reasonably expect another $65,000 in upside at the sale of the property. Assuming we achieve this, that ends up being a 20% average annual return - your $100,000 turned into $200,000. The arbitrage play looks a little better now, doesn't it? The last step is to take your additional $100K and pay off the HELOC's full balance. Voila! $100K in your pocket by leveraging your home equity. It's important to note, you could also continue making interest payments for as long as you'd like and instead reinvest the $100,000 again and again! As long as you're consistently making payments, your HELOC will stay open in perpetuity (double check this is part with your lender - some do have 10 year terms, for example).
If this strategy feels risky to you, that's understandable. Something I would challenge you to consider, though, is how most of us have been conditioned when it comes to taking on debt. It's easy to think that "leveraging the money in your home for investment" is foolish. The key is to put your debt toward investments and assets that produce income...we're not buying material things that lose value or betting on stocks with this equity. That said, every investment, regardless of what it is, has some level of risk.
If you'd like to discuss more about this topic or any other topic related to RE investing, check out our Free Guide, and I will reach out to setup a call! Thanks for reading.