Using a HELOC to Grow Wealth
Is Using a HELOC to Grow Wealth Going to Create Debt?
Should anyone use a HELOC to grow capital? Let us look at this from the bank’s perspective first.
How does a bank acquire the funds it needs to lend out to so many clients for such long periods of time? Answer: they create it.
An FDIC-insured bank or credit union is required by the FED to keep 10% of its deposits on hand. The rest can be lent out. That seems reasonable. But here is where it gets interesting. If you deposit $100,000 in a bank, they credit you that full amount but turn around and lend out $90,000 of that money to someone else. That 2nd person deposits that money in the bank. The bank must hold back 10% of that $90K and that means $9,000 will be added to the $10,000 left from your deposit.
This can continue on and on. So let us see what that looks like. Remember, this money tree is coming all from your original $100K. That’s it.
- You deposit $100,000 → The bank loans out $90,000
- Next person deposits $90,000 → Their bank loans out $81,000
- Next person deposits $81,000 → Their bank loans out $72,900
- Next person deposits $72,900 → Their bank loans out $65,610
- Next person deposits $65,610 → Their bank loans out $59,049
- Next person deposits $59,049 → Their bank loans out $53,144
- Next person deposits $53,144 → Their bank loans out $47,829
- And so on…
Your original $100K can become an imaginary, whopping $1 million in this fashion. If a bank dips below their 10% requirement on any one day, they borrow from another bank or the FED itself to close out the day with the proper balance on their sheets.
Now, imagine if those people branching off from your deposited $100K defaulted all at once. The bank would be on the hook for a lot more than the original $100K could cover. And that brings us to the point of discussing this, which is:
Banks lend/invest money they “create” (translation: DON’T have) in order to generate profits. In other words, they “invest” using debt. If this was such a risky practice, do you really think that, for the last few centuries, all the community and national banks everywhere would be going out on that limb so often and so far?
Now, to be fair, it is not quite as simple as that. Banks have robust portfolios that hedge them from the losses that come from defaults and foreclosures. Banks diversify their capital into real estate, life insurance and the stock market to name just a few. What we learn from this is that using debt is not the devil—IF you do it properly. [see an example of a major US bank’s assets as reported quarterly to the FDIC]
This blog post is not intending to go into debt practices. What we do need to determine is if using a HELOC to grow wealth is the same as using debt. The answer is NO.
The limit of your HELOC is a set number and as your balance goes down, your available equity goes up. To revisit our example from Part 1, the homeowner has now lived in a home and paid on their mortgage for 10 years. The value of the property has appreciated to $260,000 and the remaining amount owed is $123,000; which creates an equity spread of $137,000.
This homeowner has an excellent LTV ratio and can approach a bank for a first-position HELOC. This strategy is not to simply pay off the property faster (which it can do), it is designed to unlock the power of that equity to turn a liability into a liquid asset.
Typically, a bank will issue a first-position HELOC for 80-95% LTV of the appraised value. Say the homeowner finds a bank that will give them 90% LTV. Opening a HELOC for $234,000 (95% of $260,000) will establish a limit of $234,000. The mortgage will then be paid off and rolled into this HELOC. Doing this creates a balance owed of $123,000. The difference between the two numbers is the equity—which is TRUE credit. This is the value that is owned, not owed. It is true a line of credit was taken out from the bank, but it is solidly backed by collateral with intrinsic value—in this case, the home. This available capital is the opposite of debt.
Imagine this is your particular scenario. You would now be free to use the remaining $111,000 of your limit to spend/grow how you want. Ultimately, you will need to put the money back into the HELOC when the open period concludes. As long as you do not fritter away the money, that will not be a problem.
Having a HELOC does cost you interest on the balance incurred, just like a credit card would. So, you need to make sure that any financial decisions you make with that liquidated equity provide an ROI (return on investment) that is better than the interest you are being charged.
If your HELOC interest rate is 4.5%, then you need to find something that will provide at least a 5% ROI. You pay the standard income tax rate on any passive income such as interest so make the growth worth it. These are the primary factors you will want in any growth plan made with HELOC capital:
- Higher ROI then the HELOC interest rate
- As safe from risk as possible
- Liquidity as necessary to move funds back into the HELOC for payoff
Would real estate be a good choice to make with HELOC capital? That depends. Many do make this type of purchase and succeed. Being able to charge rent is a very common way to generate passive income. There are things to keep in mind as a landlord; your rights to your own property diminish by law, dealing with evictions, rights of the renter. Also keep in mind that your original HELOC will come due and require payoff. If you have not saved up enough from your real estate acquisitions or other income, that could be a tough balloon payment to swallow.
This is not to discourage you from building a real estate portfolio, but just to warn you that it takes discipline to go that route.
Alternate growth assets could be another way to go. Properly vetted and structured alternative lending vehicles tend to have fixed ROIs (some variable and variable hybrids exist), be collateralized with varying levels of risk-mitigation, as well as having maturations in timeframes of 1-5 years depending on the vehicle. This list of features can be hand-in-glove with a HELOC equity strategy.
By strategically opening up the equity of an asset like real estate, the credit earned can be used to generate more wealth for now and even for retirement. You just have to position yourself and your assets properly.
And do not forget, as you pay down the balance of your HELOC every month, your available equity credit increases. When one HELOC matures, you can open a new one and begin again. This next HELOC period will see more, if not all, of your property paid for and a yet higher appraised value. You could conceivably have 50-100% more funds for the next time around!
This strategy is coming from a positive position—a position of strength. There are even more techniques to learn about using a HELOC to grow wealth that can literally shave decades off of paying for a primary residence and even all your real estate conceivably. But, that is a topic for another blog post.
Your property has money in it that is just waiting to make you more! Contact us to learn how you can get started using the power of a properly executed HELOC to position yourself and grow your wealth and freedom!
If you missed Part I of this blog series, you can read it here.