Comparing HELOCs and Home Equity Agreements

Almost 6 months ago I was approached by a company asking to be a key resource on the blog. They wanted to advertise their services providing home equity agreements.

Honestly, before then, I never heard of home equity agreements. So, I spoke to the company and did some research. Pretty quickly, it became apparent that it was not a good fit.

Because, while touted as alternatives to HELOCs, these are very different and not a good option for doctors. And, in the first place, are HELOCs even a good option?

Let’s explore…

What is a HELOC?

I’ll start here because I’m sure many more of you are familiar with HELOCs.

HELOC stands for Home Equity Line of Credit. Essentially, HELOCs are like a credit card that you open using the equity in your house as a collateral.

Because the home is the collateral, banks are usually willing to offer lower interest rates compared to other unsecured loans. And the interest rate is usually fixed.

Thus, in essence, when you open a HELOC, you open to ability to withdraw up to a certain amount of money based on your equity in your home’s value. Then you pay that borrowed money back along with interest. The money is not taxed. The same way the money you borrow from the credit card company is not taxed. And you can use the withdrawals for whatever you want.

But, the bank puts a second lien on your home. So, if you don’t pay the money you borrow back, they can foreclose on the home. Plus, if there is a real estate market crash and you owe money to a HELOC plus your regular mortgage, you can go underwater (i.e. owe more on the home than it is worth).

So there are significant risks.

What are Home Equity Agreements?

By contract, home equity agreements or HEAs are agreements between a homeowner and an investor or company exchanging a lump sum of cash to the homeowner in exchange for a portion of the home’s future value. And this amount owed to the investor must be paid back within a certain time period or upon sale of the home.

The biggest selling point of HEAs is that there is no monthly payment like with HELOCs. So, HEA companies really push this point. But there is of course a big catch.

And that is the lump sum payment that comes due down the road.

For instance, let’s say a company offers you $50,000 for 20% of the home equity on your $500,000 home.

And then in ten years, you sell the home for $700,000. Well, now you need to pay then a lump sum of $90,000. That is, the original $50,000 plus 20% of the appreciated value (20% * $200,000).

At that point, you are paying back nearly double the loan value.

And needless to say there are stipulations that the home must be kept to a certain condition etc. But fear not, even if the home value stays the same or depreciates, you still own money on the home’s value. The house always wins.

Which is better: HELOCs or Home Equity Agreements?

HELOCs are better. Let’s get that out of the way first.

However, I still look very cautiously at HELOCs. I know some people use a HELOC very freely. But the bottom line is that it is a lien on your home, where you live. And it’s debt that you are creating. So that can be dangerous.

I know a lot of real estate investors that use a HELOC on their primary home to make a down payment on an investment property. And while debt on a properly cash flowing investment property is good debt, that falls apart in my mind when you use bad debt to fund it. Especially if the risk of missing payment on that bad debt is you lose the place where you sleep at night.

But still, a home equity agreement is way worse…

Home equity agreements are predatory. It’s another lien on your home but with worse terms.

They have very low credit score requirements and prey on people who need cash fast and can’t get it anywhere else. They tout that there are no monthly payments. And that is how they bait people into an agreement where they pay huge lump sums that they are generally not prepared for upon the home sale or at some later date.

Really bad.

Should doctors ever use a home equity agreement?

You can imagine the answer is a big, fat NO.

With our income, there should never be a reason to agree to such predatory terms while risking the home you live in.

You should have access to way better options including ever unsecured loans from companies like Doc2Doc Lending.

But really, if you are ever in a situation where you need money like this fast, what you need to focus on is controlling your expenses. It’s time for a deep look at where your money is going. You need to redefine what expenses are truly needs versus wants and make hard decisions.

Should doctors ever use a HELOC?

Maybe.

It’s certainly better than using home equity agreements. In fact, Selenid and I have a HELOC on our home. We’ve never used it. But we have it. Just in case.

And I think that is really the best use for it. It’s a back up emergency fund. And for those wondering, we would use our HELOC before we used our Roth IRA accounts as a back up emergency fund to protect our investments.

I know that I am very conservative about this but I just don’t think using a HELOC as a form of interest arbitrage for other investments, like real estate, makes sense. For the reasons I explained above. You’re putting your primary home at risk.

Either way, if you are going to use a HELOC to buy a rental property, you had better be sure your underwriting is accurate and conservative so the cash flow more than covers the usual mortgage, interest, maintenance, insurance and other costs in addition to the HELOC payments!

And this is a bit of a departure for me. In fact, I even mention this exact strategy in this post about the 3 best uses for a HELOC. Maybe I’m more conservative now as our net worth grew over $1 million…I see less need to take risk.

Other things doctors shouldn’t use a HELOC for:

Practice buy-in
Car
Home renovation
Any of the 25 things on this list

Managing debt is the foundation of financial freedom

It’s easy to get lost in the weeds as you progress on your financial journey.

But never forget the basics of how you build wealth. You build wealth by increasing and investing the margin between what you earn and what you spend.

And you build your net worth by increasing assets and decreasing liabilities.

At its core, HELOCs and Home Equity Agreements are liabilities. Granted, HEAs are way worse ones. And no doctor should ever use one.

But HELOCs still are ones as well. So they need to be used judiciously, ideally as an emergency fund or only if they will be paid back in full in a short amount of time, like a credit card.

And that’s the truth, Ruth…