A Home Equity Line of Credit (HELOC) is a line of credit secured by the equity in your home. It allows you to borrow money against the equity you have built up in your home and use it for any purpose, whether you’re looking to renovate, or invest. With a HELOC, you can tap into the equity of your home up to a pre-approved limit and pay back the borrowed amount with interest over time. As it’s secured by your home, the interest rate on a HELOC is typically lower than other forms of credit, such as credit cards or personal loans.
Let’s take a look at an example of how to use a Home Equity Line of Credit to maximize your cash flow.
Why maximize cash flow?
Rather than focusing on the lowest mortgage rate, many people instead prioritize the lowest mortgage payment. There are a number of reasons you might want to focus on your mortgage payment, but here are a few examples:
Your financial position is constrained and you need to optimize cash flow (ex: lost employment, rising variable rates, etc).
You’re a rental property investor and are more concerned with positive cash flow each month so that your investment generates income.
You’re earning a great rate of return in other investments and would rather keep investing money there than paying down your mortgage
You want to buy a more expensive house than you can currently afford, but expect a salary increase in the next few years
Whatever the reason, the goal is to maximize cash flow and we’ll discuss how a HELOC can help you.
Example: Maximizing cash flow
To demonstrate the concept of maximizing cash flow, let’s go through an example scenario. When you create a profile with our partner Perch, our mortgage advisors tailor their information to your specific situation but the benefits outlined below will be generally true regardless of your circumstances. Our scenario here assumes a $600,000 mortgage on a $750,000 property at a 4.50% fixed rate with a 25-year amortization period.
Option 1: Standard mortgage payments
In this scenario, we assume that the client only has a mortgage with no HELOC. The regular monthly mortgage payment would be $3,320.84 over the 5 year term. Of that amount, roughly $1,100 is going towards principal and $2,220 is going towards interest. Over a 5-year term, you would have paid $126,029 in interest and their remaining mortgage principal would be $526,778.
Option 2: Readvanceable HELOC
In this scenario, we assume that the client got a readvanceable HELOC with a total credit limit of $600,000 with the goal of minimizing their mortgage payment (and maximizing their monthly cash flow). The payment would still be $3,320.84, but in the first month the portion of their mortgage payment that was principal was $1,091.65 and they’d be able to withdraw that from their HELOC back into their chequing account to make their effective monthly payment $2,229.19 ($3,320.84-$1,091.65). This is 33% lower than the standard mortgage payment and can make a huge difference.
Naturally, as you increase your HELOC balance to take out the principal payments you will then start paying interest on that amount. Over a 5-year term, you would have paid $134,690 in interest and your remaining mortgage principal would be $600,000 (because you’ve made no principal payments).
How does this apply to me
So you may be wondering: why on earth would anyone want to pay extra interest? Well, there are a lot of potential reasons. Let’s name a few of them:
Buying beyond your means temporarily
Assuming the same rate and amortization, your net monthly payment on an $894,000 readvanceable HELOC would be the same as a $600,000 standard mortgage payment. That is $294,000 (+49%) in additional borrowing capacity that you can take on and could dramatically increase the budget for properties that you’re looking for.
However, the goal is that you eventually can start making principal payments and this is more geared towards home buyers that are earlier in their careers and expect higher wages in the near future. What people typically end up doing is that they buy a home that only meets their needs for the next 1-3 years because that’s all their budget can afford and then sell it to upsize into the home they qualify for later. Doing so comes at a massive cost, and we’ll use our scenario to illustrate what that could look like:
The penalty to break your 5-year fixed rate mortgage 3 years into a 5-year term:
$9,500 or more
The cost to sell your current home (legal, real estate agent, etc):
$45,000 or more
The closing costs on the next home you buy (land transfer taxes, legal, etc):
$15,000 or more
Conservatively, this person would incur around $69,500 in expenses 3 years from now to get into a larger property when they could’ve instead incurred $5,661 in additional interest. That’s not to mention the psychological benefits of not having to sell and buy a new home altogether.
Using a HELOC to invest in real estate
Typically, all interest paid on a rental property is deductible as an expense against the rental income which reduces the net cost of this strategy. Investors assume they can get better returns on their investments than the interest rates of a mortgage, so they would prefer to pay more in interest over the long term for the opportunity to have more cash now to invest. With higher net cash flow, investors can increase the size of their real estate portfolio or invest their money elsewhere.
Having the readvanceable HELOC also reduces the risks of a rental property (ex: the unit is vacant) by having the HELOC to offset lost rental income if required.