Home equity is the portion of your home that you’ve paid off plus any increase in its market value over time. In other words, it is the difference between what your property is worth and how much you still owe on your mortgage. For example, let's say you bought a home for $300,000 10 years ago and took a mortgage for $270,000 at that time. By now, you have paid off $90,000 of your mortgage leaving a mortgage balance of $180,000. Currently, the home you bought 10 years ago can be sold for $450,000. This means your home equity is:
$450,000 - $180,000 = $270,000
In the previous post, we discussed 4 ways to withdraw your home equity: 4 ways to withdraw home equity from your property. Now, we will discuss ways to invest your equity as well as a few ways to otherwise spend it.
How to use home equity. Investing home equity.
Home equity may provide you with substantially larger money than you otherwise would have access to. Consider a case when you bought a property for $300,000 ten years ago, paid off $100,000 of your mortgage, and the current price for your home might have increased to $500,000 or even $600,000. This may give you anywhere from $200,000 to $280,000 in cash for investment (if the bank gives a loan for 80% of the current value of your home).
The essence of investing your home equity is the following: you take out the equity from your property by borrowing extra cash from the bank. Then, you can invest or otherwise use this cash. As you borrow this money, you will have to pay interest. If you are able to invest this money at a return that is higher than your interest rate, you are receiving extra cash flow. For example, let say, you are able to withdraw $200,000 in home equity (borrowing at 3.25% interest) and invest it at an 8% annual return. This would mean you are making $16,000 a year in return. Then, you pay the bank the interest of $6,500. This leaves you with a $9,500 net return per year. You can then use this remaining money for spending, to pay off the loan, or reinvest again at an 8% return.
If you chose to repay the loan with the remaining $9,500, you would pay off the loan in 16 years, but would still have the $200,000 investment that continues to give you an 8% return. But now you don't have a loan to repay, so you take the full $16,000.
If you chose to reinvest the $9,500, it will take you 14 years to double your invested money ($400,000). This money (if you are able to maintain an 8% return) brings you a $32,000 return that year. You still pay interest of $6500 per year (if you can still borrow money at 3.25%) and you still have the unpaid load of $200,000. At this time, you can either pay off the loan or continue to reinvest.
If you are able to continuously and securely invest the money from the home equity at a return higher than the bank's interest, it makes sense to continue doing so as long as you can. However, you have to take into consideration the risks associated with such investments:
First, you will have to pay interest on the borrowed money, so your personal rate of investment should be higher than the interest rate to start with.
Second, in times of a bad economy, your return may go to zero or even become negative, so you have to prepare and shield against such risk.
Below are 17 potential ways to invest your home equity:
Investing Home equity in stocks.
Investing Home equity in ETFs.
Investing Home equity in Mutual funds.
Investing Home equity in Real Estate investing:
Buy to rent.
Buy to rent Airbnb style.
Buy to flip.
Buy properties at the pre-construction phase.
Investing in parking lots.
Investing in Rent-to-Own.
Joint real estate investments.
Investing in commercial properties.
Investing in Multi-unit properties.
Investing in Real Estate Investment Trust (REIT).
Investing in Mortgage Investment Corporation (MIC).
Act as a private lender.
Investing Home equity in Starting a Business.
Investing Home equity in your current business operations.
❑ Investing Home equity in stocks.
Stocks are likely the riskiest way to invest your home equity, especially for somebody who is far from the stock market. Stock prices are very volatile on normal days. In times of bad economy and financial crisis, the stock market can drop 30% or more in a matter of days. Recovery from such drops may take years. The risk increases when you invest in just a few stocks you like. With few stocks in your portfolio, in addition to the market risk, you are also exposed to individual company risk, such as the risk of bankruptcy, bad management, PR issues, etc. Think VW with its diesel scandal, Lehman Brothers, WorldCom, Enron, Chipotle with its E. coli outbreak.
However, there is a strategy for stock investing that works better than others. It is related to investing in dividend-paying companies. Stocks with dividends are a great choice for those who want to invest to generate stable passive income. Dividend stocks distribute a portion of the company's earnings to investors on a regular basis. Most American dividend stocks pay investors a set amount each quarter, and the top ones increase their payouts over time, so investors can build an annuity-like cash stream. The key is to find a stable company that pays a steady and increasing dividend that is on par or higher than the interest rate for your home equity loan.
I personally favor the stocks of Canadian banks due to heavy regulation from the Canadian government, growing revenues, profits, and a result, dividends. An example of such companies is TD bank, RBC bank, CIBC bank, Manulife insurance company, etc. Take a look at the TD bank stock price chart below. On the bottom of the chart, you can see the D circles which show it paid dividends every quarter for the past many years. It is also interesting to note that at the end of 2015, the stock price was $40, and the bank paid a quarterly dividend of $0.41, which provided a return of 4.1%. This return was already quite good and could cover the interest for the home equity loan and leave some free cash. But it gets more interesting. The quarterly dividend at the end of 2021, despite COVID, stands at $0.62. This means, if you would have bought the stock back in 2015 at $40, your current return would be 6.2%. If you hold the stock even longer, given these banks keep steadily increasing quarterly dividends, there is a reason to believe that someday you could be making above 10% in return.
❑ Investing Home equity in ETFs
An exchange-traded fund (ETF) is a type of investment fund and exchange-traded product. An ETF holds assets such as stocks, bonds, currencies, and/or commodities such as gold bars. Most ETFs are index funds: that is, they hold the same securities in the same proportions as a certain stock market index or bond market index. The most popular ETFs replicate the S&P 500 Index, the NASDAQ 100 index, the price of gold, the "growth" stocks in the Russell 1000 Index, or the index of the largest technology companies. The benefit of buying ETFs over stocks is that they remove the "company-specific" risk that we discussed above but they are still impacted by market volatility and risks. Also, as has been seen through the history of the stock market, despite drops and valleys, in the long run, the stock market keeps going up. However, you do have to be prepared for holding ETFs for a long time. Times of crisis or such events as COVID, though quite rare, offer excellent opportunities to buy stocks and ETFs as during such events they are sold at a "discount".
❑ Investing Home equity in Mutual funds.
A mutual fund is a professionally managed investment fund that pools money from many investors to purchase securities. Mutual funds are usually run by investment companies that have a team of stock analysts and a manager of the fund who make decisions about which stocks to buy or sell. There are plenty of mutual funds and if you plan to invest in those, you would need to see their past performance, the type of stocks they are trading, the bio of the manager. Over the history of mutual funds, there have been plenty of them managed by star stock gurus that continuously outperformed the market and managed to deliver an average 15 to 20% annual return. The biggest drawback of mutual funds is that they charge a fee for their services every year: a percent of your invested money regardless of whether they were able to grow your money this year.
❑ Investing Home equity in Real Estate.
There are multiple ways to invest in real estate with the money from your home equity. The ways to invest can be divided into 2 groups:
Active real estate investing: In-market investment when you actually buy, rent, and sell properties
Passive real estate investing: Investing in real estate in ways not requiring you to directly buy properties.
The way to invest in real estate depends on the amount of time and cash you want to put into it, as well as risk levels.
The key point of investing your home equity into the actual properties (active way of investing) is that the home equity money usually serves as a downpayment for the property. For the rest of the amount, you would have to secure a second mortgage. Thus, you can invest 5 times more money than you have at hand (if you put down 20% in downpayment).
Active involvement in real estate includes the following options:
Buy to rent.
With buying to rent, you obtain properties to later rent to the general public. The key watch-out with this type of investment is to make sure your cash flow is at least breakeven. Best if it is positive. By cash flow we mean the amount you get from the renter less your mortgage, tax, maintenance, and any money for fixing and tidying up the property before the next tenant moves in. Also, you have to account for the risk of a tenant suddenly moving out and having to find the next tenant, meaning no income for that period while you still have to pay a monthly mortgage. However, this problem could be mitigated by a properly done rental contract with the tenant that has to give you a several-month notice before moving out.
Another negative and unavoidable side of this type of investment is having to actively manage the property and the tenant's needs. As the owner of the property, and a person renting it out, you are obliged to make sure the utilities in the property are well functioning. This means you may have to address broken electricity, water, heating problems on short notice.
The reasons we could be OK with break-even cash flow for the first few years are:
- rent will likely go up with time.
- the tenant is in fact paying your mortgage. After a certain time, you can refinance your mortgage for a longer amortization period which will reduce your monthly mortgage payments.
- Over time, the property price is likely to also appreciate so you may sell it down the road with a partially paid mortgage and a capital gain.
- You may buy a property that requires renovation, invest in it, and charge more for rent.
Buy to rent Airbnb style.
With this type of investment, you will be required to manage the property and search for tenants on a more frequent basis. However, the right property type (usually vacation spots, cottages, and smaller apartments in the business center of the city) can bring much higher cash flow vs. a simple buy-to-rent option.
Buy to flip.
With this type of investment, you buy less attractive properties to renovate and sell for a higher price. This is a very special way to invest in real estate which requires not only the knowledge of the real estate market and good timing for the purchase. You also have to do a cost analysis for the cost of the required renovation and have the ability to predict the future value of the property after the renovations.
Buying properties at the pre-construction phase.
With this type of investment, you are trading time for money, meaning all you have to do is invest and wait for the construction to be complete. The idea behind this investment is simple: the construction companies very often have more projects than they can afford and are always strapped for cash. Rather than borrowing the money from banks, they borrow this money from you at the pre-construction phase, offering to buy future property at prices that are lower than the expected market price when the construction is done. The key risks here are the potential delays in construction which can lock your money, the inability of the construction company to complete the construction, and the decrease in the value of homes by the time they finish construction.
Investing in parking lots.
There are 2 ways to invest in parking lots. The first is buying individual parking spaces in condos to rent them out. However, this option usually offers lower potential value appreciation but can bring constant cash flow. The second way is to buy full outside parking lots. This is a more interesting way to invest as the key point of buying parking lots is the land they are on. If you strongly believe that this or that area is about to grow and people will be buying real estate there, you can buy a parking lot to wait for the land appreciation and then sell it to other investors for building a property on it. Also, while you wait for the land appreciation, you will be receiving a monthly cash flow from the parking fees.
Investing in Rent-to-Own.
I wrote an article about Rent-to-Own from the side of a tenant here: What is Rent-to-Own? How does Rent-To-Own work? However, this round, you would be on the other side of the transaction and will act as an investor. With this type of investment, you would sign a contract with the tenant to rent it for a set term (usually 3 years). Before starting rent-to-own, the tenant would put a downpayment for the property. During the rent-to-own term, the tenant pays you a monthly fee, part of which goes towards their downpayment. At the end of the term, you are obliged to sell this property and the tenant has to buy it. If the tenant cannot buy the property at the end of the term or otherwise exits the contract in the middle of the term, the tenant loses the original downpayment and all the monthly downpayment payments.
Joint real estate investments.
Joint real estate investments are not really a set way to invest. Rather it speaks to a point of reducing the amount you have to invest and risk by going joint with other parties. There are many groups of investors on social media that look to partner with others for joint investment opportunities because they have the property in mind, but don't have enough cash. They are willing to partner with other investors to invest and share the income. Joint investing can be done for any type of real-estate engagement, be it renting, flipping, buying parking lots, commercial real estate, multi-unit investment, etc.
Investing in commercial properties
Investing in Multi-unit properties
The last 2 types of investments mentioned above are more complex, are riskier due to the large amount of cash needed, and require more knowledge and experience in real estate. As such, they require a separate in-depth description that will be covered in future posts.
Passive real estate investments. Investing in real estate in ways not requiring you to directly buy properties.
Investing in Real Estate Investment Trust (REIT)
A real estate investment trust (REIT) is a company that owns, operates, or finances income-generating real estate. Modeled after mutual funds, REITs pool the capital of numerous investors. This makes it possible for individual investors to earn dividends from real estate investments—without having to buy, manage, or finance any properties themselves.
Investing in Mortgage Investment Corporation (MIC)
A mortgage investment corporation (MIC) is a corporation that enables small investors to invest in a diversified pool of mortgages on residential real estate with the benefit of using the corporate form by purchasing shares in the corporation.
Acting as a private lender
When you act as a private lender you become a sort of a bank that lends money to those who cannot get a loan from a bank for buying houses. Usually, these are people with bad credit scores, people new to the country, self-employed people.
❑ Investing Home equity in Starting a Business.
If you are thinking about starting a business, the money from your home equity may be that initial capital that you need. The benefit of using home equity is the relative ease of access compared to a business loan that will require the business plan and financial proof that you will be able to return the loan. Also, depending on the type of your tapping into your home equity (home equity loan, HELOC, or cash-out refinance), you may get better rates than you would get for a business loan.
❑ Investing Home equity in your current business operations.
While it is harder to get a business loan for a new business, banks are more likely to give you a business loan for your running business operations or expanding your business. This is because you will likely have a few years of financial statements to prove your financial standing. However, there is usually a limit to how much a bank is willing to lend for your business loan. In such cases, you can access your home equity to invest it into your running business.
Potential ways to spend your home equity
Home improvements.
College costs.
Debt consolidation.
Emergency expenses.
Wedding expenses.
Business expenses.
I am not going to go into ways to spend the money from your home equity. I believe everyone is an expert in this area.
In all cases, keep in mind that the money you take out from your equity today, you will have to return back with interest. Indeed, there are cases when the money is needed and there are no other ways to source them, such as debt consolidation, covering your emergency expenses, or covering your business expenses that if not covered may result in shutting down your business. In some cases, such as home improvement, college costs, debt consolidation, and business expenses, the money you spend today may result in future benefits. For example, investing in renovations may improve the value of your property, consolidating debt may result in a lower interest that you have to pay, investing in education or business may help you get better in life. In each case, you have to think the situation through and calculate the cost (future interest and principal payments) and the benefit. Looking at the cost vs. benefit tradeoff will help you make the final decision.