I often get asked about how HELOCs can or maybe should be used. Additionally, Selenid and I opened a HELOC on our primary home about a year ago. So, I think it will be interesting to explore what a HELOC is, what the best uses are for a HELOC, and why we opened one on our home.
What is a HELOC?
HELOC is an acronym for Home Equity Line of Credit. It took me a little bit to fully grasp what exactly a HELOC is. But in reality it’s fairly simple.
A HELOC is essentially a credit line, like a credit card, that you open. And this credit line is backed or secured by the equity in your home.
So, if you have $100,000 of equity in your home, you can use this to open a line of credit. In general, most lenders will open a HELOC for 75% LTV or loan to value of the equity. So $100,000 of equity equals a HELOC of $75,000.
Once you have the HELOC open, it just sits there, like a credit card. If you use any or all amount of the HELOC, then you need to pay it back. Again like a credit card. There is an associated interest rate obviously for these payments.
And if you don’t pay back the money you borrow from the HELOC…the lender gets your home! That’s right. The lender takes a second lien position on your home when you open a HELOC.
This is different than a cash-out refinance
In a cash-out refinance, you are restructuring the debt on your property. You are taking out a new loan for the new appreciated value of the property while the lender pays you the difference between your old loan and the new property value.
This results in a new, higher, steady monthly mortgage payment in exchange for a lump sum of equity cash.
You can see how we used a cash-out refi of one of our investment properties to help finance another one here.
This is not the same as a HELOC. A HELOC is a line of credit. You actual mortgage payments don’t change.
How do you open a HELOC?
This part is pretty simple. You just shop around for lenders that offer HELOCs and search for the one with the best rate.
Once you find one with the best rate and terms, they will perform an appraisal of your home to determine your equity. Then they will create the HELOC and have you sign a bunch of papers.
Then your HELOC account is open and the money is available to you to borrow.
Importantly, if you never use the HELOC, it just sits there. No fees or anything like that. Just like if you have a credit card open but never use it.
Can you open a HELOC on a rental property?
This is a very common question about HELOCs. The answer is a very conditional yes. I am told there are lenders who will give out HELOCs on investment properties.
But I have not actually found one yet.
The reason is fairly obvious. Lenders worry that borrowers and HELOC-openers will be higher risk to default on an investment property than on their own home.
I would imagine rates and terms to be worse when I do finally find a lender to open a HELOC on a rental property.
The only potential exception is a short term rental which may technically qualify as a second primary home. HELOCs are more likely in this scenario. I believe that Ian Cook of CarpeDiemMD has done this.
What are the best uses for a HELOC?
Now that we know what exactly a HELOC is and how it works, are there actually uses for it?
In my opinion, the answer is yes. But the actual best uses for the HELOC likely differ from what most believe. Remember, a HELOC is essentially a low-moderate interest rate credit card. But the price you pay for that lower rates relative to unsecured credit cards is the potential to lose your home. That’s a big price.
So, why do I say there are actually best uses for a HELOC despite this high price to pay? Because there is both good and bad debt. We need to make sure that we are using our HELOC as a form of good debt when we use it.
With this perspective in mind, I see 3 best uses for a HELOC…
No, I’m not cold. It’s still summer in Buffalo as I write this.
BRRRR is a real estate investing strategy that stands for Buy, Rehab, Rent, Refinance, Repeat.
It’s a useful strategy in which you buy a distressed property that won’t qualify for traditional lender financing (because it is not livable in its current state). Therefore, you need to buy it in cash.
After buying it, you fix it up (using cash) after which you rent it out. In its now improved and cash flowing state, the property is worth much more. So, you do a cash-out refinance of the property based on its new value. In order for the BRRRR to work, the amount of cash you receive back should be equal to or greater than the amount of cash used to buy and rehab the property. And the cash flow needs to cover the now increased mortgage along with all other expenses.
Anyway, this is a great strategy when the numbers work right (more on that here). But you need cash up front to buy and rehab the property.
You can get this cash in a number of ways:
- Just save enough actual cash,
- Hard money lending, or
- From a HELOC
The safest way to do this is saving the actual amount of cash. But if your numbers are solid, you may be able to do the BRRRR with OPM (other people’s money). In terms of OPM, hard money comes with massive interest rates.
Therefore, in this case, it is reasonable to use a HELOC
Remember, good debt is debt that pays you more than you owe on it. In this example, you take the money out of the HELOC and then put it all right back after you hit the Refinance portion of the BRRRR equation.
So, the HELOC is allowing you to purchase a cash flowing rental property. That’s an example of good debt.
2. Buying a cash-flowing rental property the traditional way
Here’s another example of good debt although this one comes with a bit of an asterisk*.
You could also use a HELOC to pay for all or some of a cash flowing rental property that you buy via traditional financing via a mortgage. Essentially you could use the HELOC as a down payment or to pay for rehab costs.
This only works again if you are using the HELOC as good debt.
This means that your expected cash-on-cash return for the property is 10% or greater after all expenses including the HELOC payments are accounted for. Your margins will be a lot tighter and just waiting until you save enough cash is advisable, but this is an option.
The asterisk* here is that you are essentially putting up your primary home as collateral for your investment property. So you better be pretty damn sure that your numbers work before doing this! Please prime yourself and make sure you understand how return metrics in real estate are calculated using this post.
3. An emergency fund’s emergency fund
I went back and forth on including this as a one of the best uses for a HELOC. Mostly because this is not an example of using a HELOC as good debt.
Anyway, I have had multiple financial experts tell me that an emergency fund is necessary if you have a HELOC. “Why keep cash for an emergency when you can just draw from your HELOC anytime?”
Unfortunately, for me, this logic falls apart immediately. It’s like asking, “Why keep cash for an emergency when you can just use a credit card?”
No one would take that advice. But for some reason the former seems appealing. I get that HELOC interest rates are lower than credit card. But it’s still debt that is not generating a return. That’s bad debt.
So, why do I have this one here?
Well, I don’t think it’s ridiculous to have an emergency fund of 3-6 month’s worth of expenses in cash or a HYSA (this is the right way to invest an emergency fund!) while also having a HELOC available.
The HELOC is there in the catastrophic event that something happens that even your emergency fund can’t handle and you need to supplement it.
What could such a catastrophic event be? I have absolutely no idea and I hope I never do. Keep in mind, I don’t think it’s necessary to have this emergency fund’s emergency fund HELOC. But it’s certainly an acceptable function.
Why did Selenid and I open a HELOC on our primary home?
Basically, for all three of these reasons. Or we wouldn’t have done it.
We love the idea of having the HELOC available if a great BRRRR opportunity comes around.
We also love to have it just in case some amazing traditional investing opportunity comes around and we need to supplement our cash. In this case, we would pay off the HELOC as immediately as possible once the cash was accumulated. It just gives us flexibility in timing.
And the idea that it could cover above and beyond our emergency fund is reassuring, however unlikely given our adequate life, disability, malpractice, and umbrella insurance policies.
What Types of Insurance Do Doctors Actually Need?
There’s nothing to lose in these cases. With our HELOC, as long as we keep it open 3 years, there are no fees ever and we can close without fees after that time period.
I’ll be 100% honest though…I’m not sure that we will ever actually use it. But we decided to open it just to have available in case one of these events arises!
Looking for more information about financing real estate deals as a doctor?
- A Real Estate Investing Guide for Physicians
- 401k vs Real Estate: Which Is Best?
- How to Use Debt to Buy Real Estate (& Why You Should)
- 7 Simple Steps to Obtain an Investment Property
What do you think? What are the best uses for a HELOC? Do you have a HELOC? Did I miss any other reasonable uses? Let me know in the comments below!