What is HELOC and How Does it Work?
HELOC is a consumer loan that allows you to secure low-cost funds in the form of a second mortgage against the equity built in your property. In simple words, it is a line of credit to buy a new property.
To benefit from this line of credit, you would put up your property as collateral to ensure the lender that you will pay the loan back in time.
Like credit cards, as you repay the balance, the amount of credit is replenished, which means you can borrow more loans against it if you need to.
The kicker?
The consumer loan you are entitled to is strictly determined by the equity balance you have in the property.
For instance, if you have a $200,000 inequity in a specific property, you may find a lender that will give you 70% LTV, which concludes to a line of credit equal to $140,000.
What is the Draw Period?
Most HELOCs establish draw periods that allow the lender to use the credit, followed by another period to repay the loan. Then, as a borrower, you are extended 5 to 10 years where you only pay interest on what the pending balance is, like credit cards.
How to purchase an investment property via HELOC?
Unlike conventional home equity loans, the HELOC does not give the total amount upfront. Instead, you can consume the open line of credit until you reach the predetermined amount based on your home equity.
Firstly, It has to be repaid with minimum monthly interest payments on the amount borrowed.
Secondly, the line of credit doesn’t go up as you pay down the principal amount on your mortgage. Generally, you need 20% of the down payment to finance a new purchase.
Determine the amount you want to borrow
HELOC prompts a limited percentage to be borrowed by the consumers. So before taking your home equity, calculate how much amount you need to borrow. When it comes to financing, different banks follow discreet regulations to offer HELOC.
For starters, banks are less inclined to lend on investment properties. As a result, you can often access only 85% of the equity in your home.
To estimate that percentage subtract the loan balance from the property’s appraised value. This becomes your second mortgage.
For example, if you get an appraisal of $350,000, your current loan balance is $250,000, you will get $100,000 in equity. So the optimal value that a lender is going to finance is $85,000 in this scenario.
Special consideration while using a HELOC on an investment property
Lenders look into your overall financial status, assets, the Debt-income-ratio, credit score, cash flow, previous debt payment record, and available cash cushion.
You will end up paying an inflated annual percentage to keep it manageable.
You have to prove to the lender that taking out another loan won’t unbalance your current income to debt ratio with a good credit score.
The lender will thoroughly analyze if you can afford to borrow more, in addition to what you already owe.
Once your line of credit is approved, now you have actual numbers to decide which investment property to invest in.
The costs associated with HELOC are inclusive of application, appraisal, and lender’s fee.
For example, if the investment property HELOC is for $20,000, the average closing cost would range between $400 -$1000.
A few takeaways to Help Purchase a Property in cash
- Don’t exceed more than 50% of your HELOC limit usage. The notion is to protect your credit just in case the recession rolls in; you don’t want to be caught in a hefty amount of balance on your hands.
- Don’t let your debt accumulate more than 70% of the property’s value.
- It is advisable to utilize 50% of your HELOC to limit the purchase of an investment property outright. As the HELOC is readily accessible, it facilitates you in purchasing an investment property in cash.
- If you get a HELOC on a 3.99% interest rate and generate cash flow between 9-12% by investment properties, you can conveniently pay off the HELOC at a faster rate. Focus on getting the HELOC balance down to zero to rinse and repeat. It enables you to create more cash flow to pay off your next HELOC balance.
Conclusion
The easiest way to think about a HELOC is it’s a credit card. It is a meticulously curated pathway to build loan strategies for your investments. You can borrow money from it, then pay it and again borrow money from it.
But you have to be cautious while paying back the loan because it may jeopardize your primary home if you cannot handle the payments.
Looking forward to joining you all in this journey to Financial Freedom & Education!
