Tapping into home equity at today’s low interest rates can provide the savvy investor a means to actually make a profit on the equity idly sitting in their home. With the proper planning and execution, home equity can be used to increase the wealth of the homeowner by using arbitrage. Arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices.
Many homeowners have built a substantial amount of equity in their homes which just sits idle, doing nothing for them.
For example what is the rate of return on your home equity? If you accumulate equity in your house is that equity going to help your home go up in value? If you own a home that has a large equity reserve or is paid off, it’s not going to change in value any faster than if you own that home fully mortgaged right? A residential property’s value will not change based on the amount of equity it has, it only changes based on market value.
So if equity in a home isn’t helping it to appreciate in value then what is the equity actually doing? The answer is — absolutely nothing.
Using Arbitrage With A HELOC To Leverage Your Home Equity
Unless you can use that equity as investment capital with arbitrage, the rate of return on the equity in your home is always zero. From an investment perspective, it makes no sense to keep one of your largest assets (your home) sitting idle and earning a zero percent return. Conversely if you can extract a portion of your equity at a low interest rate and invest it at a rate that pays a higher return, you are using arbitrage to get that passive equity performing for you. How does this work?
For example, if you have $200,000 of equity in your property based upon current market value of $500,000 and your mortgage of $300,000, and you have a lender who will provide you a Home Equity Line of Credit (HELOC) for 80% of your property’s full value:
Property Value: $500,000
Loan Balance: $300,000
HELOC: $100,000 (80% of $500k value=$400k, minus current mortgage of $300k)
Assuming you can borrows up to $100,000 of your home’s equity via the HELOC, at a current market rate of 4%, and then invest that money into a fund that pays 8%, then you have successfully created a 4% earning on your home equity. This represents a gain of $4,000 per year of passive income from the equity that was sitting idle in your home. If you factor-in the tax deductions
HELOC Risks And Rewards
With relatively low interest rates and tax-deductible interest, home equity lines of credit (HELOCs) have always been considered the best choice when it comes to home improvement loans. But while they might be the top lending tool for homeowners, HELOCs have their fair share of risks.
A home equity line of credit (HELOC) has many tangible benefits, but it is a loan and it needs to be used with diligence, otherwise the risks may outweigh the rewards. Here are five examples items to consider when it comes to home equity loans.
1. Low payments, little equity gained
A HELOC has a very attractive feature-the minimum monthly payment need only cover interest costs. A loan amount of $30,000, for example, might only require a minimum payment of $200. This allows you to float the balance from month to month. Over the long haul, however, if you make only the minimum payment, you’ll never pay off any principal, and the loan will never go away. The solution is to make sure that you have a plan to repay the loan or, if feasible refinance your property to include it in your main mortgage balance.
2. Interest rates rise
Interest rates on HELOCs are usually based on the prime rate, which tends to hover in the single-digit range. A HELOC’s loan rate is variable, however, and usually rises when the Federal Reserve increases rates to stem inflation. These increases can come quickly and may climb 2 percent or more. As a result, that low minimum payment will increase. Be sure that there is enough difference in your arbitrage calculations to accommodate a rise in the interest rate on your borrowed funds.
3. Hammered by hidden fees
Lenders lose money when borrowers refinance loans with another institution. To keep their loans in-house, lenders will tack on early-termination fees. These can be either a set fee, or a percentage of the loan balance. Before you take out the loan, look for a lender who doesn’t impose these types of fees.
4. Losing home value
Another risk is that your home may decrease in value while you’re borrowing more money. When it comes time to sell the house or refinance the loan, you may find that the equity that you had counted on has suddenly disappeared. Avoid this problem by making sure that the total amount of your home loans doesn’t equal more than 80 percent of the house’s market value. If your property is located in an area with declining home values, you may not want to use a HELOC in this capacity.
5. Borrowing unwisely
A HELOC works well if you’re borrowing for home improvements or to invest in a fund that has a capital return. If you’re borrowing to finance a vacation or to pay down other debt, this may not be the most sensible use of a HELOC since your debt will stay with you until the last cent is repaid.
HELOCs have plenty of upside; but every homeowner’s situation is different. As with any financial tool, you need to consider all the potential risks, as well as the rewards. A HELOC is a great option-just make sure it’s the right one for you.