Using a Home Equity Loan to Invest
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Since 2012, home values have surged past the highs we saw before the Great Recession— and with increasing home values, many homeowners are finding themselves sitting on a nice chunk of home equity. At the same time, mortgage rates, while rising, are still at historic lows.
The combination of relatively low rates and high property values can make a pretty compelling case to tap into that equity, lock in what are still arguably reasonable rates and get a home equity loan.
“While this poses an obvious challenge for those looking to purchase homes, those who own homes are benefiting from an increase in their housing wealth,” Tendayi Kapfidze, chief economist at LendingTree, wrote in a recent study on home equity loans.
Even more interesting is the idea that the home equity loan can then be used to invest in something new, whether that’s a business venture, an income property or some other asset, in hopes of generating a profit that exceeds the cost of their loan. Kapfidze recently analyzed LendingTree home equity loan requests in 2018, and found that about 8% of home equity borrowers have the same idea, and are using the funds for some type of investment purpose.
While great on the surface, the idea of taking an equity loan at a low rate and turning it into a profit through investment is one that should come with careful consideration, risk evaluation and a thorough understanding of the potential pitfalls of the investment you’re considering.
This guide will give you an overview of some of the ways you can use your home equity loan as an investment and some of the drawbacks of doing so. Inside, you’ll learn about:
- Home equity loans for investment
- Types of investments
- General pitfalls of borrowing against your home equity
- Finding your comfort zone
Using home equity loans to invest
The general idea behind using a home equity loan for investing is to grow the investment to a value that exceeds the cost of the loan — i.e., the interest rate, closing costs and other fees.
That means homeowners must do a different type of assessment than they would if they were using a home equity loan for debt consolidation.
“With debt consolidation, you are replacing one kind of debt with less expensive debt, so you are coming out ahead. But if you are making an investment, you are taking an extra risk,” said Kapfidze.
In general, to help control and understand this risk, there are four factors you want to consider before deciding what kind of investment to make:
Your credit score: The interest rate you get on a home equity loan is determined by many factors, including your credit score. The better your score, the lower your interest rate will likely be and the less growth your investment will need before it creates a profit.
Cost of the investment: Investments have different costs. Housing flips have carrying costs between the time the property is purchased and the property is sold, stocks and mutual funds have commissions and fees, and so on. Each of these costs should be added to the interest on the loan to determine the total expense. Adam P. Smith, president and CEO of mortgage brokerage firm Core Finance Group, notes that the loan terms and investment earning power can sometimes be at odds. “If borrowers are in a position where their risk tolerance is low and their investments are going to be conservative, then it may not pay the kind of dividends that they would need to offset the debt,” Smith said.
The timeline: Some investments may have a relatively short time frame for return. Others, such as education, may take years to pay off. In the meantime, you will still have to carry that loan expense.
Tax implications. When using an equity loan to make home improvements, or buy or build a home, a borrower may be able to deduct interest paid toward home equity loans of up to $750,000 (for couples filing jointly). However, it should also be noted that the Tax Cuts and Job Act restricts a borrower’s ability to take an itemized tax deduction for interest on a mortgage used to make other investments.
Types of investments
In Kapfidze’s study of home equity loan purposes, he found that the most popular investment made with home equity loans was improving a home, so let’s look at that investment type first.
Using a home equity loan to invest in home improvements
Home improvements are one of the few investments that not only have the potential to help homeowners create a profit once they sell their remodeled home, but they can also be enjoyed by the homeowners before they sell. However, there can be a downside. Homeowners need to research the types of projects that offer the best returns in their area. They also need to control costs and not personalize the remodeling too much. Finally, they should consider how soon after the remodel they plan to sell, because according to research conducted by remodeling, a home improvement magazine, in some areas homeowners will get more in resale value if they sell within a year of making the changes.
The next most popular investment use of home equity loans in the study was for other related purposes, which can include stock market investing, paying for educational expenses and starting a business.
Using a home equity loan to pay for education
Investing in college classes, trade school classes, and designations within a career discipline can reward a student with better job opportunities and income. In that case, using a home equity loan might sound like a wise way to pay for it. You’re investing in your future earning potential.
To measure the potential return, we can look at the U.S. Bureau of Labor Statistics and see that as of 2017, the unemployment rate among those with a bachelor’s degree was markedly less than those with a high school diploma. Further, those with a bachelor’s degree averaged a salary more than 50% higher than those with a high school diploma. But even education isn’t a sure thing.
Before taking an equity loan, homeowners need to compare the cost of their degree versus earning potential within their field and the rate they’d get on a traditional federal student loan. If you finance education with a federal student loan, you’re not only getting access to potentially lower interest rates but you also have access to flexible repayment plans if you can’t afford your payments. On the other hand, if you stop paying a home equity loan, you could lose your home.
A home equity loan may seem like an easier, straightforward option if you are looking to invest in a business or grow your own business.
Tom Hutchens, senior vice president of sales and marketing for Atlanta Georgia’s Angel Oak Mortgage Solutions, said this could be due to the difficult process of securing a business loan.
“Getting a mortgage can be a pretty simple process. Qualifying for business loans requires a deeper dive into the business itself,” Hutchens said. “With your home, you have instant equity right there, already.”
But, it’s worth noting that the U.S. Bureau of Labor Statistics reports that only 50% of businesses with employees make it at least five years, which is why business owners should have a plan for continuing to pay for the loan even if their business fails.
Stock market investing
Investing in the stock market comes with no guarantees, but watching the growth of the S&P 500 over the past 10 years may encourage some homeowners to use home equity loan proceeds to invest in the markets. According to North Carolina financial adviser John Mazza of Southeast Financial Services, Inc., homeowners taking this step need to focus on the long term.
“Taking a loan out against a property to try to capture the next unicorn is incredibly risky,” he said. “Everybody wants the unicorn, but slow and steady wins the race with the markets.”
Investing in another property
Finally, let’s take a look at investing in another property. While not one of the more popular uses of an equity loan, investing in another property is notable because borrowers using loan proceeds for this purpose had the highest property values and requested loan amounts.
Whether it’s house flipping or buying a rental property, real estate investments are one option being explored by some borrowers. A recent report by ATTOM Data Solutions noted that in 2016, home flipping gross returns hit 49.8%, the second highest average return since this data started being tracked in 2000. But flipping is not without risks. Sellers need to have an in-depth understanding of the market they’re going into, how to price to move the inventory quickly, have strong relationships with contractors doing the work and know that they can support the carrying costs of the flip until it’s sold.
General pitfalls of borrowing against your home equity
We’ve discussed the individual investment concerns, now let’s take a look at two common pitfalls that could befall anyone taking out a home equity loan for investment.
Risk of foreclosure. No matter how successful (or unsuccessful) an investment may turn out to be, a home equity loan still needs to be paid, and if it isn’t, borrowers could lose their home. Homeowners should have a plan for paying off the loan even if their investment falls through, and for many that can mean limiting the amount they borrow so they can more easily maintain the payment.
Estate planning: If estate planning is a priority for a homeowner, then they need to consider how an equity loan will impact the legacy they leave behind. Homeowners may want to make sure that the estate has funds to continue making loan payments through probate, and they may want to increase life insurance death benefits to cover the loan.
Finding your comfort zone
One of the ways to reduce the overall risk presented by the home equity loan is to borrow the right amount. What might that be? Well, it depends on your unique situation, but some of the factors that go into determining the correct amount include:
Don’t push your loan debt higher than 80% of your home’s value. This will give you a cushion against dropping property values and ensure you don’t need to get private mortgage insurance.
Compare loans. Some loans may have higher interest rates, higher closing costs, balloon payments, prepayment penalties and other terms that increase your overall expenses, so make sure you’re comparing offers to get the best one. You can compare home equity loan offers at LendingTree.com.
Get a payment you can afford — no matter how your investment does. To keep the home you’re using as collateral, you’ll need to continue making payments on your loan regardless of whether your investment performs as expected. Rather than borrow based on how you hope your investment does, consider borrowing based on what you can afford without a return on your investment.
With careful consideration, a full understanding of potential risks and methodical planning, homeowners may find that low interest rates combined with rising home values give them a powerful means of securing equity funds for investments. Before taking out a loan, homeowners should make sure that they fully understand how much time it could take for their investment to pay off, and ways to insulate themselves from the risks inherent in this type of transaction.