Buying a house is an exciting and stressful adventure, especially for those doing it for the first time. Real estate will be the biggest investment for a lot of people, but it shouldn't be your only investment. As with any portfolio, it's important to stay diversified. This is especially important when considering the equity in your home as part of your overall investment portfolio.
As with any one stock, it's vital to stay weighted and balanced with your investments, and never be too overweight in any one investment. The same can be said for a home. Taking advantage of a home equity line of credit, or HELOC, can be quite advantageous to diversify your investments if used wisely and responsibly.
The idea of a HELOC is to have a line of credit equal to a portion of a home's equity (a portion of mortgage you've paid down already). This portion is any amount paid down on a mortgage that is greater than 20% of the mortgage value. In other words, in order to qualify for a HELOC, a minimum of 20% must be paid down on a real estate property. This is one added benefit, in addition to avoiding CMHC fees, of putting down 20% on a property upon purchase. Ideally, a HELOC should be used to invest money elsewhere to compound this equity that would instead be sitting idle in one's home generating no additional value. Using this money for frivolous spending is simply stupid because you are essentially erasing equity that was once yours. Taking that money out for investing is simply moving one piece of the pie somewhere else. You still own that piece of pie regardless of where it is.
An annual interest is due on the line of credit once pulled. The interest is usually equal to the prime bank interest rate plus a premium (0.5% for example). Therefore, the rate of return from an investment that one would be using a HELOC for should exceed the interest paid on the HELOC amount in order for the investment to be worthwhile in the first place. Any interest paid on a line of credit used for investing is tax deductible from other income (rental income, dividends), similar to how commission fees are treated against realized stock investment gains (gains on stocks are calculated after subtracting commission fees).
Let's look at a simple example. Let's say Jane owns a $400,000 house. She has paid off $150,000 of it so far. She would qualify for a HELOC of $70,000 ($150k minus 20% of $400k). Her remaining mortgage would still be $250,000, but she has access to pull out $70,000. Figure 1 illustrates the break down of monies:
Figure 1: Jane's House Breakdown
Jane could pull out $70,000 on a line of credit to use for investing purposes. At a prime rate of 2.7%, her annual fee for this line of credit would be $2240, or 3.2% (prime rate plus 0.5%) of $70k. Her investments, on average over a 5 year period, earns 7%, or $4900 annually. In other words, her $70,000 equity is earning her net $2660 annually instead of just sitting idle in her home providing no additional returns.
It is also quite common for individuals to use a HELOC to invest in a rental property to create monthly rental income. Not only is the rental property generating income, but both the rental and primary property are generating value by price appreciation over time. The beauty about house price appreciation is that the credit segment grows proportionally.
Let's say Jane gets a reappraisal done on her house, and the new appraised value is $450,000. Suddenly, the credit segment she can access grows from $70,000 to $110,000. The mortgage remaining of $250,000 doesn't change, and the new 20% required amount for a line of credit is based off of the new appraised value of $450,000, amounting to $90,000. Therefore, what's left over, is the available credit segment, totaling $110,000. Figure 2 illustrates this breakdown:
Figure 2: Jane's House Breakdown after Appraisal
In some rare cases, the maximum line of credit rule can apply. This is the case where an individual has paid off the majority of a property (greater than or equal to 85% of the equity). In other words, a 15% mortgage segment must always exists if a HELOC is pulled, along with the minimum required 20% down to have the line of credit option available. If someone has fully paid off their house, the maximum HELOC they would be able to have is 65% of the equity:
Maximum HELOC Scenario:
- 20% Equity
- 65% HELOC
- 15% Mortgage Segment
Using a credit segment from the equity of your own home can also be quite risky if not done responsibly. One of the primary causes of the 2008 financial crisis was the abuse of HELOCs nation wide by people who over leveraged themselves and used these line of credits for purchases of things they couldn't afford to keep. Of course, regulations around pre-approvals for HELOCs back then were more relaxed as well, leading to many individuals having the power to pull line of credits off their home who not only had poor credit scores, but also had very little paid down on their primary residence and secondary properties (there was no ability to afford their cost of capital or their mortgage).
However, if done responsibly, dividing up the equity of your home can be a great way to expedite the growth of one's net worth, and overall investment holdings. After all, real estate is just one slice of the investment portfolio pie, and it's up to you to determine how big of a slice of the pie you are comfortable with.