AMA - Investing with Home Equity

This question is from Anthony and Julia in Brooklyn.

Hi Victor.

I’ve been listening to your podcast for about a year now and appreciate what you’re doing!  I have my wife, who is an architect, listening in now too! We want to invest in other real estate but with two young boys we don’t have a lot of disposable income to work with.

We own and live in a double duplex in Brooklyn. We bought in 2013 and after significant work and neighborhood development its has more than doubled in value. On our block alone there is a lot of studio and one bedroom apartment development going on.  We’d like to access some of the equity we have built up in our property.  We’ve been renting the lower unit short term for about 4 years, but that business is getting less attractive.  We are considering condominium conversion and selling half to capture money to buy other property or renting out both units and taking out a HELOC or do a Cash Out Refi. Ideally we’d like to hold because the neighborhood has a lot of growing yet to do.  Our interest rate seems kind of high at 4.875%.

What are your opinions of Helocs vs Home Equity Loans for less experienced eager to grow investors?

Sorry for the sprawling question but I hope you can speak to some of these issues.

Thanks for taking the time and we look forward to learning more from your show!

Anthony and Julia

Let’s look at the condo conversion option. While it’s certainly possible to do a condo conversion, it’s not very practical for such a small condo project. The overhead of managing a condo corporation for the rest of time quite frankly is hardly worth it for two units. The shared common elements between the two units can become a source of friction between unit holders. For a small property you’re better off keeping it all together and not subdividing it in my opinion.

A sale of the lower unit that you don’t occupy would free up some equity, but it might also be considered a taxable event.  A refinance on the other hand isn’t a taxable event. It offers you a lot more flexibility in terms of what to buy, and when to buy it.

Let’s start by describing the difference between a home equity loan and a home equity line of credit. A home equity loan would basically be a refinance of your existing two unit property. It would be for a fixed amount of money and rates these days a pretty good. You have a couple of choices in this. If you work with your existing lender, they may be willing to put a second loan on the property while maintaining the original loan. That way, there’s no pre-payment penalty for refinancing the old loan.

The second choice is to replace your existing financing with a new loan up to the new loan amount. Remember, at this stage, the lender assumes that the path to repaying the loan is primarily from your employment income for both of you. They will generally give you credit for the rental income in the second unit, but they will typically want to see a 12 month lease. Short term rentals usually don’t fit with most bank’s lending model.

The third choice is the home equity line of credit. The difference between the line of credit and the home equity loan is the way the funds are advanced, the way the interest is calculated and the way the loan is repaid.

The loan is an amortized loan which means that the monthly payments include both principal and interest.

A line of credit simply requires that the interest be paid monthly. If you’re using the equity in your home to buy another property you probably want to use the equity on an ongoing basis without being forced to repay it on a monthly basis. For that reason, the home equity line of credit might be a better fit. The home equity line of credit also has the advantage that you’re not paying interest on monies you don’t use.