Leveraging- Using equity in your house

by Karen

I learn tons of useful information from my first venture in real estate investment. And it got easier with each second and third purchase because I knew what to expect. Finding fund for down payment was also easier because I could leverage equity in my house for my next house purchase.

You hear this word before:” Leveraging”, sounds fancy and important, right? In a nutshell, it just means: borrowing money to invest. The beauty of leveraging is cheap borrowing cost which allows you to buy more investments than you’d otherwise be able to, thus increase your returns in short time. The downside is just as obvious. If your investment goes south, you will end up owning a lot of money to your creditor. With cheap borrowing, you can use the fund as down payment to invest in another house or invest in other investments such as stocks, mutual funds and so on that can give you a better return.

How to Leverage

It’s often said that fortunes are built with other people’s money. Empires got started with borrowed money, so you certainly can take the same approach. I have been leveraging my homeowner line of credit to invest in both stocks and real estate for more than a decade and I am happy to say I have gained more in return than the cost of borrowing of the fund. Having said that, I will emphasize that leveraging has risks and you should always thoroughly research before diving in. At the end of the day, it is your name on the I.O.U agreement with your bank so be cautious of how you will invest the fund.  There are ways to leverage your house.

Option 1- Home Equity Line of Credit

Essentially, it is a line of credit with your house as the collateral for the debt. If you already have a mortgage on the house, the lender will register a second lien on your home. Since you offer your house as collateral for the debt, your lender will most likely offer you a lower interest rate than an unsecured line of credit. This can be a great way for you to come up with fund needed for a down payment for a rental property investment.

Once you receive monthly rental income from the rental properties, you can pay just the interest and keep the excess money or invest the extra fund in other investments. Money makes money!  The other great thing about line of credit is flexibility on debt advance date. You can borrow when you want, and when you pay down on the line of credit balance, you can re-borrow again. It is not a coincident that the line of credit is flexible and convenience to use. Lenders want to make it as easy for you to spend as possible. When given access to a lot of funds and at a cheap borrowing rate, we tend to binge on spending.

When I was a lender, I came across customers who borrowed against their home owner line of credit to go on “retail therapy” or worst, gambling. Needless to say, those weren’t wise decisions. Just remember! Your home is used as collateral for this debt, so spend WISELY!

Option 2- Second mortgage or Home Equity Loan

In some cases, where the borrower has delinquent credit repayment history, the lender may not approve a line of credit. Instead, the lender may ask for an installment loan or mortgage repayment loan to ensure the debt will be repaid on time and provide the borrower with repayment discipline. The great news is this option is cheaper cost of borrowing compared to unsecured loan! The not so good news is: it is not flexible. The loan is advance on a fixed date and you will have to re-apply when you need more fund.

Option 3 – Refinancing

It just means: terminating your existing mortgage and increasing the balance by the additional funds you need. Similar to option 2, you will get both the good and bad of this option.

Now, let’s get into the “how”

How a lender determines the maximum equity available on your house? For Canada, the lender will take 80% of your house appraised value then subtracts your existing debt balance that secured against your house (i.e: mortgage, homeowner line of credit and/or loan) to find the maximum equity available in your house. This can be a bit hard to digest so let’s just take my situation as an example:

I paid $200,000 for my first home and with $15,000 down payment, so my mortgage was $185,000 at closing. Then fast forward few years later, I wanted to borrow more money using the house equity. My mortgage balance was down to $175,000. Now I know what you must be thinking: lady, you don’t have enough equity in the house: $200,000 * 80%= $160,000. That’s more than your mortgage balance of $175,000. Well, luck was somewhat on my side. A combination of house price inflation and renovation that I did to the house increased the value from $200,000 to $800,000 appraised value. So, let’s take a look at the math again. $800,000 *80% – $175,000 = $425,000. Money made money indeed.

So why do I want to borrow cheap money by leveraging my home?

Because I want to use the lower cost of borrowing line of credit to invest into something else that will give me a much higher rate of return. As I mentioned, there are risks in leveraging, but you may want to take the risks if the rate of return is attractive enough for you. One of the most common reason for people to leverage is to obtain fund to invest in real estate or stock. I have been leveraging my house’s equity to invest in real estate for over a decade. In long term, I can make substantial gain if the property value appreciates, and I can also make small gain from positive cash flow in the short term.

Positive cashflow is an interesting topic in real estate investing because most investors want to have positive cash flow so they don’t have to pay money out of their pocket each month if there is a shortfall.  All of us have our own personal risk tolerance level. With leverage, it is important for you to find a balance between reducing your down payment and ensuring you still have cash on hand at the end of the month if your budget is tight and you can’t afford to pay out of your pocket each month covering for your investment property’s negative cashflow (shortfall). Negative cash flow should be avoided in almost all situations as it will:

  • Force you to look for cash or income to feed this monthly cash shortfall when you may not have extra cash lying around. That just not ideal situation to be in
  • Likely impact your credit history and that will negatively impact your ability to seek credit in the future if you are unable to repay your debt on time

First, assess your financial situation

Both situations aren’t good news for you and that is why a balance must be struck. To avoid negative cash flow situation when leveraging, I recommend you complete an honest and simple math to determine if you will be able to support this extra debt on your current income. For example:

  • I brought a $400,000 a townhouse to rent out with $80,000 down payment and a $320,000 mortgage
  • I leveraged my homeowner line of credit for the $80,000 down payment and had to make a min $240 monthly interest only payment
  • Conservatively, I could receive $2,200 rent per month based on location of the property and market condition
  • Now, let’s do the math: $2,200 (rent income) – $1,400 (monthly mortgage payment) – $240 (Line of credit monthly minimum payment) – $ 210 (monthly property tax) – $150 (maintenance fee) – $25 (monthly solid wastes and water payment) – $80 (property insurance cost) – $34 (alarm service cost) = $61 surplus

I had a positive cash flow for this investment property. As you can see, it is easy math to determine the cash flow of your investment property. If you want to do the cash flow calculation before making the purchase of the investment property, I recommend you take a look at the average rent in the neighborhood of the property and take the lowest amount as your potential rent income. Basically, you want to plan for the worst-case scenario (i.e: you will be getting the lowest rental income possible), and if you still make a small surplus, then YEAH! Now, if you end up getting more than the lowest forecasted rent income, then you will have more cash in your pocket. Plan for the worst and hope for the best!

Negative isn’t always bad?

Now, I will say something silly which is the benefit of negative cashflow in real estate investing. How can it be a benefit when you have to pay money out of your pocket every month because your investment property has negative cash flow? Yes, it can be if you are in a high enough income bracket. Well, this is true if you are a Canadian. I don’t know about American tax code on real estate investing. For Canadian, the investment loss that you take on as a result of negative cash flow on your investment property can be used to lower amount of tax you need to pay.

A friend of mine purposely invested in a property that incurred negative cashflow (shortfall) for years to reduce his income tax. He was a private banker and made really good bonus! I know, those private bankers. I encourage you to consult with your accountant on this topic because each person’s income bracket and financial situation is unique, so talk to a professional who has good knowledge of the tax code.

Getting back to my pitiful $61 monthly surplus. It isn’t great and it doesn’t do anything for my immediate monthly cash, but it has been a great investment in a long run. In a period of 4 years, the value of the townhouse increased from $410,000 to estimated $570,000. I haven’t made any improvement to the property, it has been just purely value appreciation due to market demand. So, if I want to sell the townhouse, I would make an estimated $160,000 gain. That would mean a 114% return on my initial investment which was $80,000 down payment plus additional $60,000 on closing cost ($140,000 in total).  Not bad for 4 years, right?

So, find the balance that works for you. You can achieve tremendous positive cash flow, yet very little (if any) equity appreciation and the reverse is also true. Like any type of investing or in life, you need to be certain of what is your risk tolerant and what you can live with.  So be cautious and do the math before making your bet! I hope you find this posting useful. As always, write to me about your experience or question on this topic. I love to hear from you.

 

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