Using a HELOC to Grow Wealth
Is Using a HELOC to Grow Wealth Dangerous?—Part I
Due to the concern of some fairly well-known financial pundits, a number of wage earners have been, let us say, “reluctant” to try any sort of strategy that begins with incurring a debt. This two-part series will ask and answer the question: is using a HELOC to grow wealth the same as using debt? In part one, we will also go over the HELOC concept in general and learn how it can be used.
The most naked way to use debt to grow money would be to take out an unsecured bank loan and put that money in the stock market. This method is essentially the same as buying lotto tickets with a credit card or betting it all on black at your local casino. But is using HELOC capital the same thing?
What is a HELOC?
A HELOC is a home equity line of credit. You get this product from a bank. It is a way to pay for real estate just like a mortgage is; but that’s about where the similarities end. Properly used, a HELOC can not only help you pay your property off faster, it can help you save on interest and also allow for your home’s equity to earn its own capital.
Briefly, a mortgage is a lender (usually a bank) investing in you for a 15-30 year term for the amount your real estate is sold to you for. The lender is paid their profit through the interest rate you pay on your loan. They make sure to pay themselves first by a repayment structure called amortization. Essentially, the first half of your mortgage note is paying primarily the profit to the lender and the second half is paying for the property itself.
A HELOC is also money fronted to you by a bank but the way you can use it is very different. Let us say your house is worth $200,000. A bank will generally issue a HELOC for 80-90% LTV (loan-to-value), so this means you could buy that property with a HELOC as long as you have some money down. We will be conservative. If you find a bank that will issue you a HELOC for 85% LTV, then you would need to have $30,000 in addition to the $170,000 HELOC issuance. So far, this isn’t anything novel—you qualify for mortgages similarly. Here is where it gets interesting.
While mortgages and HELOCs consist of amounts of money you owe to a lender, a mortgage is paid out of your pocket and you never see that money again. It goes to the bank for their use. A HELOC is different. It is essentially a giant-size credit card. You can keep reusing the limit on a credit card as many times as you like. The amount of “credit” available to you is the only limitation on what you can spend.
Using the model of a credit card will help you to comprehend a HELOC if this is a new financial concept for you. When you are issued a new credit card, you have a limit, and this is the amount of money you can charge to the card. After you begin charging items to the card, you now incur a balance. The balance is what you owe back to the credit card company. Your spending limit is reduced as your balance increases.
If you have a maxed out credit card, you then have no available limit until you make a payment. Any payment on the principal will open up the ability to charge once again. This charge/pay/charge cycle is available to you to keep up as long as you own that card.
How Can a HELOC Be Used to Grow Wealth?
The HELOC works like a credit card except for one way.
The puzzle with a credit card is that its name is highly ironic. The “credit” you are issued is, in reality, debt. To truly be a “credit” card, your card limit would need to be collateralized with a valued asset. Use of the card would then be leveraging against that collateral and the limit would be based on the maximum value of that asset. Credit cards have no such underpinning to collateral. Your limit is solely based on the unsecured risk the credit card company is willing to take on you.
A HELOC is based on an asset with intrinsic value—in this case, your real estate property. The credit available in a HELOC is fully funded by the value of your property. To state it simply, if your house was worth nothing, your HELOC would be worth nothing. They match up.
HELOCs tend to be issued at an LTV ratio of 80-90%. You can sometimes find banks that will do 95% or even up to 100% in certain circumstances. But we will stay conservative with our examples. A HELOC issued for a new purchase at, say, 80% will be fully maxed out. Your balance will be 80% of your home’s fair market value. As you make payments into your HELOC account, you reduce your balance and start to open up your limit. The limit that becomes available to you as payments are made is the equity you own in the property that is now being unlocked and liquidated!
In a scenario where a HELOC is being used for the full amount of purchase, it will be some time before the balance has been lowered substantially enough to allow for appreciable asset growth. But you do need to start somewhere.*
*It should be mentioned that most mortgages that are higher than 80% LTV will include PMI (private mortgage insurance) in your monthly payment. This is generally NOT the case with a HELOC—making it a more attractive way to fund a real estate purchase in and of itself. Of course, there are other benefits we aren’t covering in this blog post. (Ok, one benefit: check with your tax advisor if HELOC interest may be tax-deductable for your home under the TCJA Tax Law*)
Let us move to another common scenario that many Americans find themselves in. You have been in your home for 10 years paying a mortgage on a monthly basis. You purchased your home for $200,000 and now owe $123,000. It is impossible to predict what the appreciation of any piece of real estate will be in the future but the market average is ~3-5% a year. In the 10 years you have been in your home, not only have you been paying down your principal, your residence has also been increasing in value. If it has averaged 3% growth per year, your home’s value will now be around $260,000. The difference between what you owe and what your property’s appraised value is is your total equity.
When we do the math, the equity available in this scenario is $137,000. That is a substantial amount! But, the equity in this form does you absolutely no good. You are paying for the mortgage, the taxes, the insurance, the upkeep—but are not earning anything from this investment.
Meanwhile, your lender is profiting nicely from their investment in you. By this time (10 years), you have paid over half of the interest you owe for the loan you took. In fact, looking at this situation from an asset/liability standpoint, your home is not an investment for you. It is an investment for the bank. Your home makes the bank money but it costs you. The secret most have not been taught is how to unlock the power of their own equity to turn their biggest liability into their biggest asset!
Check out part two of this series where we learn if HELOCs creates debt.
Internal Revenue Service “Interest on Home Equity Loans Often Still Deductible Under New Law.” Accessed May 12, 2020. (back to paragraph)