Summary: Our readers often ask us, “Should I Use a HELOC or Cash-Out Refi to Fund My Next Property?” In this post, we discuss the pros and cons of a HELOC vs. cash-out-refi so that you can decide which is the best option for you to use to fund your next investment.
[Disclaimer: We are not accountants, lawyers or financial advisors, so please consult your own team of professionals about the topics covered in this article.]
If you’re actively growing your rental portfolio like us, you’ve probably run out of money to invest.
Even the savviest of investors reach a point where they’ve got to get creative about financing future investments. If you’ve reached this point, then the time has come for you to go find other sources of money for your next down payment.
One obvious source of funds is the equity in your primary residence. For some, this is untouchable. For those who are able to overcome the fear of tapping into this equity, you have two main options. Your options for accessing these funds are: getting a home equity line of credit (HELOC) or a cash-out refinance (refi for short).
So, should you choose a HELOC or a cash-out-refi, and why?
In this post, we discuss the pros and cons of each so you can decide which option is the best for you.
If you need a primer on HELOCs and cash-out refis, please read this article first!
Why do a HELOC or a cash-out-refi to fund my next property in the first place?
Getting a HELOC or doing a cash-out-refi allows you to access the equity that you’ve built up in your home. This equity builds up as you pay down the mortgage or when the home appreciates in value.
People tend to hold on to their primary homes for long periods of time. Therefore, it’s not unusual to build up a fair amount of equity over the years.
While most people just let that equity sit in their homes, real estate investors often choose to tap into this equity to fund their investments and build an additional source of income.
Your property has to appreciate above a certain threshold for you to be able to pull the equity out of the home. The banks determine this threshold, called loan-to-value (LTV). They will only lend up to a certain amount based on the current value of your home.
For example, if a bank offers you a 70% loan-to-value (LTV), they will only lend you 70% of the current value of the home. Therefore, the bank will only lend you $350,000 if your home is appraised at $500,000.
When you do a cash-out-refi, the proceeds are used to pay off your first loan. After which, you can use whatever is left over to invest with.
For example, if you have a $200,000 mortgage on the home in the example above, you’d have $150,000 left over to invest after you pay back the first mortgage.
Keep in mind, doing a cash-out refi will likely increase your mortgage payment so you’ll need to budget for that.
One other benefit of doing a HELOC or cash-out refi to fund your next property is that the money you borrow is tax free. Therefore, in the above example, $150,000 can be pulled out without paying any taxes on it.
HELOC or a cash-out-refi Pros and Cons
HELOC
Pros
- You don’t make any payments until you borrow the money.
- Closing costs are usually lower than the closing costs for a cash-out refi.
- If your current loan is really favorable (low interest rate), with a HELOC, you can keep your current loan.
- You may be able to borrow more with a HELOC than you would with a cash-out refi (for example, you may be able to borrow as much as 85% LTV vs. 80% with a cash-out refi).
Cons
- Interest rates tend to be higher with a HELOC vs a loan you would get by doing a cash out refi.
- A HELOC usually comes with a much shorter loan term than a typical mortgage term, with a minimum of 10 years.
- You will be making both a monthly payment on your existing mortgage and your payment on the HELOC.
- The rate is adjustable. Over time it can increase or decrease according to designated benchmarks.
- Pre Covid, HELOC’s could get a 89.99% CLTV (Combined Loan To Value). Covid pushed a lot of the HELOC’s down to 85% CLTV. However, as the markets become more and more healthy we will see the higher CLTV’s come back and be more prevalent.
Cash-out Refi
Pros
- You are paying down the loan with each monthly payment. Therefore, you are slowly building equity in your property.
- You will only have to worry about making one monthly payment, which will be for your mortgage, vs two with a HELOC.
- A cash-out refi usually comes with a longer loan term than a HELOC. Usually a minimum of 15 and a maximum of 30 years.
- Lower interest rates than what you would get with a HELOC.
- A stable rate vs an adjustable one with a HELOC.
Cons
- You have to start making payments on the loan even if you don’t use that money for an investment.
- You have to pay closing costs, which are usually between 3%-6% of the amount financed.
- Usually a cash-out refi will extend the timeframe for paying off your mortgage.
- Refinancing requires you to pay off your old loan.
- If the terms of the old loan were good, you may be refinancing into a less favorable loan.
Conclusion
In summary, both getting a HELOC or a cash-out-refi on your primary residence are tax-free ways to get money out of your property. Both options have pros and cons. Both can be great ways to fund your next investment, it just depends on what works best for you! If you put that money towards purchasing a rental, you are using tax-free appreciation to bring in cashflow. Which results in that cashflow being even sweeter!
