Utilizing Your Equity: Doing the Math

Investor Question:

I have about $120,000 equity in my house and would like to utilize it to pay off some debt and invest in real estate. Should I take out a second mortgage or get a line of credit?
Expert Answer:

Financing questions can be tricky for investors and consumers alike. And because there are so many options, trying to decide what makes the most sense for you can be very overwhelming. Every situation is different, and because of this, there is no all-encompassing answer to your question. Instead, here are some tips and pointers designed to assist your decision-making and help you to determine the path that is best for you.



The 14-Second Loan

At Keystone, we like home equity lines-of-credit (HELOC) because they provide rapid access to capital at competitive rates. As investors, they allow us to tap into our equity in about 14 seconds without any bank hassles, simply by writing a cheque against our HELOC. This provides a lot of flexibility to act quickly when the right opportunity appears.



However, the 14-second loan is not the cure-all many people believe it to be. Before using a HELOC for your investments, we urge you to consider some key factors. Teaser rates on equity lines are usually very attractive but over time they are more expensive than good fixed-rate financing. If you intend on tying up more then $50,000 for a long time – you will probably be better off either wrapping the balance into a refinance or considering a fixed rate second mortgage (a closed-end home equity loan).



Also, HELOC rates are generally adjusted on a shorter timescale than traditional mortgages. If interest rates go up one week it is possible your HELOC payment could rise as soon as the following week.



Also, it pays to know how a HELOC appears on your credit report. A HELOC with a large limit and small balance looks good on your credit ratios. A tapped out HELOC will look like a maxed out, high balance credit card and not a mortgage on your report, causing a drag on your credit.



Seconds Anyone?

If you know you need a specific amount for an investment, consider a closed-end equity loan (second mortgage). You’ll give up the flexibility of a HELOC, but it will be cheaper and more credit friendly.



The primary consideration for whether to get a second mortgage or refinance your primary mortgage comes down to a simple mathematical equation. If you are smart (or lucky) enough to have a mortgage from 2 years ago at 4.25% fixed over five years, you probably won’t want to mess with it any time soon. Generally speaking, primary mortgage rates are lower than secondary mortgage rates, especially if the second mortgage crosses the 75% equity threshold. Talk to your mortgage officer and they will quickly and easily apply this formula to your situation.



Let’s say you have a primary mortgage for $200,000 at 6%. You want to acquire two new investment properties and are looking at a second mortgage/refinance boot of $120,000. Current second mortgage rates would be about 7.5%:



Primary Mortgage

($200k @ 6%, 25 year amortization)

$1,279.61



Second Mortgage

($120K @ 7.5%, 25 year amortization)

$877.86



Total Payments

$2,047.38



Now, if you refinanced for the same 6%, your payment would be around $2,047.38 for a savings of $110.09 per month. This method should help paint a clearer picture of your financial options but we urge you to factor in all the additional costs before moving on because the bigger issue comes when you weigh your financing options.



For example should you trade long-term fixed primary financing for short-term adjustable rate financing? As a rule, we like fixed financing. Even when we can get better adjustable rates we would rather look long-term. Also, it is a good idea to assign some penalty factor to adjustable rates so you get an accurate understanding. Too many people give up good long-term rates for short-term payment relief. If possible, avoid that situation.



One Last Thing...

When you are running your investment return calculations do not forget to factor in the financing costs and interest on your seed money - especially if it comes from a HELOC. Many people treat it like free money when it should be accounted for in your projections.



If you have more questions about financing, visit a qualified investment real estate or mortgage professional and fully explain your financial needs and personal plan. Remember, sacrificing investment stability for short-term gains is rarely a good plan. Finally, make sure you are working with a mortgage professional who has your long-term interest in mind.