Go Broke To Win Big HELOC Edition – Maximize Your Home Equity

Some of you have asked me to write about property, a topic still dear to me despite the correction. First and foremost, I believe a property is not so much an investment but a lifestyle decision. When we choose to buy property, we’re choosing to plant roots in a neighborhood we love, and build our lives accordingly. Not to say you can’t do the same renting. When you have a large financial commitment to your abode, you tend to be less transient, all with a heightened sense of awareness that your home brings you great pleasure but also great financial responsibility.

When people get in the mindset of buying a property to flip, things can go seriously wrong due to the illiquid nature of the asset and the high transaction costs. Although the hurt in property has been broadcast everyday in every media outlet for the past year, less than 3% of the housing stock trades a year. In other words, the large majority of property owners shouldn’t be affected unless they just had to sell today. This is not a post about the merits of owning vs. renting, a topic which we can get into later.

Buying property is relatively straightforward. Your high tax bracket is killing you, you have at least 30% of the properties’ value in cash so that you can put 20% down and have a 10% buffer, you believe you’ll live in the place for 5-7 years, the rental yield compares favorably with the current gov’t 10 yr risk free rate, the place is nicer than anything available in the rental stock, and the location is good, so you buy. Let’s assume you own a piece of property, and you’ve got a nice big fat juicy Home Equity Line of Credit (HELOC). You’ve noticed the HELOC rate drop to an outrageously low interest rate equal to Prime, or 3.25%. What do you do with it?

Folks have literally gone broke using their HELOC’s as a way to fund a lifestyle beyond what their salaries can support. When these homeowners go broke, it affects others who’ve been responsible in their home finances due to foreclosures and higher borrowing costs. This leads to a cascade of hurt, as consumer spending shuts down and everybody begins to wallow in the mire like we have over the past 1-2 years. It’s easy to highlight what NOT to do with your HELOC. Don’t use your HELOC to fly your buddies to Vegas and bet on the ponies after a night clubbing on whoever knows what else. Don’t use your HELOC to invest in the stock market and leverage up like I did several years ago! Don’t use your HELOC to buy you and your husband a vacation to Paris. Keep the use of your HELOC entirely related to your house.

GOING BROKE TO WIN BIG – HELOC EDITION!

The #1 thing you should do with your HELOC is to spend your HELOC! What you say? Let me explain. HELOC’s are generally a quick and easy debt tool with currently a much lower interest rate than anything else out there. While Citibank jacks up my credit card rate from 8% to 15% (while taking government money and giving 50% raises to many of their employees), HELOC levels are hovering between 3.25% to 5.25%, depending on your credit. If you utilize your HELOC, you MUST ONLY use the HELOC to pay down higher interest baring debt such as credit cards and student loans, and/or to pay down the principal in your primary mortgage. Don’t even use your HELOC to pay off debt from another residence, because that property might disappear in an earthquake. Compartmentalize your debt and don’t co-mingle!

I have a $100,000 HELOC which had been tempting me for years. With my HELOC interest rate at 3.25%, it was a full 2% lower than my rental property’s primary mortgage rate of 5.25%. Readers know I have a car problem, and I longed to use the HELOC on a weekly basis to buy myself a Porsche 911 CS Cabriolet or a more reasonable BMW 335i Coupe. Last year, I decided to use the entire $100,000 not on a shiny new toy that can go 0-60 in 4.5 seconds, but on paying down $100,000 in my rental property mortgage. Let’s do the math and set up the example as to why this is a good thing.

Say my primary mortgage was $400,000 at $2,250/month amortizing at a fixed rate over 30 years. Of the $2,250, 75% was going to interest and 25% or $600 was going to pay down the principal every month. What happens when $100,000 is used to pay down principal? Absolutely nothing to how much you have to pay every month if you have a fixed amortizing loan. You’re still paying $2,250/month, but your amortization period has shrunk from 30 years left to in this case 21 years because you’re paying $2,250/month for $300,000 left in principal (not $400,000) AND the mix of $2,250/month has shifted towards now 50% going to principal instead of just 25% i.e. $1,000 vs. $600 for an increase of $400/month.

Great you say, but what about the cost of the HELOC? The HELOC at 3.25% will cost you monthly interest of $271/month. So your total cash outlay goes from $2,250/month for your rental property to now $2,250+$271 = $2,510. Not that much more, and for rental properties, the primary goal is to pay the mortgage off ASAP to reap the full rental income. Essentially, you’re cutting up a portion of your principal debt so that $100,000 of the $400,000 is being paid back at 3.25% and the other $300,000 remains at 5.25%. You’re paying $271/month to get $400/month if you will. You are going broke, in the sense that you’ve utilized your entire HELOC with nothing left, while raising your monthly cash outlay for the good of your finances. Arbitrage is a wonderful thing and should be repeated infinitely!

INFLATION CAVEAT

To put the above math another way, the difference of (5.25% and 3.25%) X $100,000 = $2000/yr in interest savings if you were to use your HELOC to pay down your mortgage and rates stayed the SAME for the life of the loan. This is the tricky part, because US treasury bonds have been in a 30 year bull market, interest rates trended lower over the same time period. If you are expecting massive amount of inflation due to all this government spending, then you may not want to utilize this strategy. However, I don’t expect inflation for another 2-3 years due to the large economic output gap. Do know that even if we get inflation sooner than expected, the interest rate will take time to adjust. You won’t wake up one day with Bank of America saying BAM, here’s your new 8% Home Equity Line of Credit rate!

If you benefit from the 2% interest rate difference for 12 months, you will need your HELOC rate to rise to 7.25% for 12 months to negate your previous 12-month benefit. This is unlikely to occur, and even if it did, you’ve paid down $100,000 of your principal anyway and you have at least 2 years to adjust to start attacking your HELOC if the rate stays higher. Clearly, the bigger the spread between your HELOC rate and your primary mortgage rate, the more attractive this method is. I would use a 2% buffer as the minimum before employing this method, but if you’ve got plenty of cash on the sidelines, you may find a narrower spread more acceptable.

KNOW THYSELF!

You have to know yourself before you go through with this Going Broke HELOC plan. If you have the discipline to pay an extra 10% of your mortgage payment in principal, and not use your HELOC for wasteful things, then you don’t have to follow this method. If you know you will spend your HELOC on things unrelated to your house, and have the income to afford the extra monthly HELOC expense, then you should consider this plan. Even if you never plan to use the HELOC, you should employ this method because of the arbitrage. Going Broke To Win Big HELOC Edition is much like the concept of paying yourself first. You pay down your debt first, and keep paying more of it first thing every month before spending. We have the resiliency to adapt to less monthly cash flow quickly, and will reap the rewards down the road.

You need to REALLY HATE paying more for debt when cheaper debt comes along. Not only am I taking advantage of Bernanke’s monetary easing, I will also continue to pay a hundred bucks here and there towards my primary monthly principal anyway because 5.25% is a good guaranteed return on my money. And if inflation does return, then by definition your debt becomes cheaper as inflated dollars are used to pay down your majority fixed debt, and your assets, including your house and your income will inflate higher as well. Whether to pay off your mortgage is another hearty debate we can discuss later on. In a nutshell, pay off your rental property mortgage as quickly as possible, and it depends for your primary residence.

Going Broke to Win Big HELOC Edition does three things: 1) It removes all temptation of using your HELOC for stupid things because it’s no longer there, 2) It pays down your mortgage quicker and cheaper, and 3) It fully utilizes your HELOC before some bank decides to just take it away! You should have a cash buffer in your bank account at least a quarter the size of your HELOC just in case the increased monthly payments get to you. Your HELOC is not considered your cash buffer by the way! With a $25,000 cash buffer in this example, you have 90 months of cushion to pay that extra $271/month.

If you’re serious about paying off your debt and reaching financial freedom sooner, consider this method now as rates are low. We need to use debt when the timing is right, and not let debt use us! The sooner you can get out of debt, the sooner you’ll be able to set yourself free. If at the end of the day you decide this HELOC strategy is not for you, that’s fine. Whatever you do, don’t use your HELOC for anything but emergencies. Once you start using it to fund your lifestyle, it becomes very difficult to stop. If you think having a $10,000 credit card limit is dangerous, just imagine what happens if you have 10X that? In the meantime, keep enjoying your home and the wonderful memories.

Readers, please feel free to share your thoughts on the subject and whether you think rates will go up, and how high over a specific time frame. The 10 year yield has rebounded to 3.7% as treasuries have sold off in light of a strong equity market recovery. I don’t think the 10-year treasury yield will break 5% over the next two years, thereby keeping mortgage and HELOC rates low. Of course, this is just my opinion, and only you can make the choice most appropriate according to your financial situation.

TERMS FROM POST REVISTED:

HELOC: Home Equity Line of Credit. Banks will offer this line of credit based on the equity in your home. If you put down 20% on a $1 million house, it’s generally quite easy to take out a 10% HELOC or $100,000. Banks make money not only by your $1 million mortgage, but also when you use your $100,000 HELOC as well. However, you win when rates plummet, and you can use your lower rate HELOC to pay down your higher rate primary loan. Hence, if you are refinancing or purchasing a home, definitely get a HELOC. It’s a free option to utilize in low rate environments.

10-Yr US Treasury Yield: The risk free long bond rate one would earn if one invested in US 10-yr government bonds. This is my main barometer in assessing risk and returns. 30-year mortgage rates follow the 10-yr treasury yield. Right now, the spread is narrow, as 30-yr conforming loans can be had for 5.35% vs. 3.7% on the 10-yr i.e. 1.65% spread.

Rental Yield: Rental yield is simply your yearly annual rent divided by the purchase price of your property. You definitely want to beat the 10-yr Us Treasury risk free yield. Why would you buy a place that gives you a rental yield of 3%, with all the hassle when you can just buy a 10-yr UST earning 3.7% and do nothing! People did so b/c they thought property prices would always go up. In this market, demand a rental yield at least 2% more than the risk free treasury rate.

Economic Output Gap: The difference between the actual output of an economy and the output it could achieve when it is most efficient, or at full capacity. There are two types of output gaps: positive and negative. A positive output gap occurs when actual output is more than the full-capacity output. Negative output gap occurs when actual output is less than full-capacity output. The output gap is currently around -7-8% i.e there’s a lot of slack, hence I’m not too worried about inflation.

Recommendations For Homebuyers Or Homeowners:

* Check Your Credit Score: Take a moment to check your free TransUnion credit score through GoFreeCredit.com, a company I trust. 30% of credit reports have errors, which could put a serious hamper on your refinancing or new loan borrowing abilities. I had a $8 late payment I didn’t even know I owed crush my score by 100 points come up during my last refinance! The average credit score for rejected mortgage borrowers has risen to 729 due to more stringent lending requirements. Do you know what your score is?

* Refinance Your Mortgage. LendingTree Mortgage Refinance offers some of the lowest refinance rates because they have a huge network of lenders to provide mortgage loans, home equity loans, and home equity lines of credit. If you’re looking to buy a new home, consider using LendingTree to get multiple offer comparisons in a matter of minutes. When banks compete, you win.

Updated: 2014. The bull market in real estate is alive and well!

Regards,

Sam

Sam started Financial Samurai in 2009 during the depths of the financial crisis as a way to make sense of chaos. After 13 years working on Wall Street, Sam decided to retire in 2012 to utilize everything he learned in business school to focus on online entrepreneurship.

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Comments

  1. Anonymous says

    Nice post. I never thought about using a heloc that way. I think you make a good point that they shouldn't be used for splurges. Charlie

  2. apprenticeoflife says

    Very educational. I have never thought about using HELOC til recently. I thought I would use it to either 1) start a business, or 2) buy foreclosed properties; without using my own cash and also getting soem tax deductions. But reading your post re not comingling one's debts is making me rethink.

  3. theroadtomeaning says

    Great article

    I will consider the HELOC in the future and I agree that money should not be spent on material needs or impulse spending.

  4. says

    Apprenticeoflife and Anon, thnx for your comments. It all depends on how risky you want to be. Thousands of businesses fail every year, and if you dump your HELOC into starting your business and it fails, it becomes a double whammy. Or, you could hit it big while funding your start up for cheap.

    Using your HELOC to buy properties got people in a lot of trouble over the past few years. The property bought loses 20% of value, then your HELOC gets wiped out, yet u still have to pay the HELOC.

    Don't hold back on your dreams apprentice, I'd would just find some other way to raise that money for your business i.e someone else's money! Use your HELOC to arbitrage your debt away, or make smart & necessary home remodeling choices.

    Best,

    Sam

  5. Ryan says

    I'll one up you. I don't think a HELOC is a good idea at all. I think it's just more debt that's priced exactly where it should be according to the risk/reward profile for the bank. It's cheaper debt because you're offering your house as collateral.

    When I was a kid, in upper middle class America in the 1980's, they weren't called HELOC's, they were called "Second Mortgages." Somebody in the neighborhood who had gotten a "second mortgage" was whispered about in hushed tones as if he had filed for divorce.

    "Do you know Richard and Helen took out a second mortgage?"

    "Oh no! Really? Did he lose his job?"

    "We're thinking his business must be way down."

    "Well, I'm sure his drinking isn't helping."

    "What a shame, how sad for the kids."

    "I know, I feel terrible."

    And this was in the 1980's, folks, I'm not even 30 yet.

    And RB, you cite illiquidity as a reason house flipping can go horribly wrong. I think the real reason has more to do with extremely high leveraging more so than illiquidity. You can sell any house in a week for the right price; and the prices are not THAT volatile, certainly not as volatile in the short term as individual equities. But if you're leveraged 10 to 1, or more, then you might not be able to sell at all, which I guess makes it illiquid for you, but that's not the cause of the problem.

  6. Financial Samurai says

    Hi Ryan – Thnx for your commentary. It's definitely been a culture shift the way Americans use debt, and housing debt that's for sure. In many countries around the world, include robust China, their savings rate is over 20% compared to our measly 4% now (was negative for a long while).

    The heard mentality in equities and property is incredible. Property prices in Taiwan for example dipped 10-20% over the past 10 months from the peak and have rebounded by 20-30% over the past 3 months… just like that. Even today's stock market is just a juggernaut now, where when we were at sub 700 on the S&P, everybody was expecting us to go to 500.

    At any rate, it's harder to get out of property in a down market than equities, as the bid ask spread is just that much wider. The property I buy is for the lifestyle I want to lead. And if it so happens i can cash out with a gain in 20 years, wonderful. But, I'm not counting on it, and neither should most people.

    Best,

    Sam

  7. Dan says

    “for rental properties, the primary goal is to pay the mortgage off ASAP to reap the full rental income.”

    I have been taking the opposite approach. I would prefer to keep mortgages, even refi w cash out, and keep my cash for more purchases. The buildings still cash flow and I can expand my re portfolio. Once I am satisfied w the number of units I own and I have extra cash then maybe I would think about paying down mortgages. The mortgage doesn’t bother me as long as buildings are cash flowing and I am putting my cash to good use.

  8. Helocinvestor says

    I used my $100,000 (3.75% now) to invest not in my mortgage but a passive investment with minimal risk and only a 90-day exit window on principle. I’m earning between 8-11.5% on the HELOC funds, netting me an average of 5+%.

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