Money Mindset

Money Mindset discusses the experiences and opinions of a middle-aged professional on the topic of money, including: financial planners, investment experiences, part-time income sources, real estate investment and private sales, web site income opportunities, changing professions, home office organization, money education for kids, and many other subjects I have experienced first hand or even just thought about.

Thursday, February 23, 2006

Making use of home equity for investing

Before I started investing in real estate, I really thought it was years away before I could gather enough money to put into investments of this size. After I read a few books on real estate investing I realized that this wasn't true. I discovered that being the owner of my own residence makes it very possible because there is often value that you can borrow against for putting downpayments on investment properties.

Secured Lines of Credit

The concept of a secured line of credit can make it much more achievable. What I did was take out a secured line of credit on my house. First of all, I used a mortgage broker that can shop around for the best rates. They also know how to approach the lenders who give the kinds of terms you need as a real estate investor.

The main mortgage lenders in Canada will usually lend up to 75% of the value of your house on a line of credit that is really a mortgage (either a first or second mortgage). They will not usually allow you to owe more than 85% on your house in total mortgages. When you are borrowing more than 75% of the value of your house, the portion above 75% usually costs you in terms of a higher interest rate (eg. 10% rates or more, compared to 5 or 6% for a first mortgage of no more than 75%).

The equity is defined as the difference between the current appraised value of your house (what they think you could sell the house for), and what you still owe on the house. As long as you are not going above 75% (or 85% for a second mortgage) in debt, you may be able to borrow against equity that has been accumulating as you pay down your mortgage, or as your house appreciates in value.

An Example Line of Credit for Investment

If I bought a house for $100K with a 25% downpayment (75% mortgaged) 10 years ago, I might have paid down $20K, and maybe I now owe just $65K on the mortgage. In that 10 years, my house might have appreciated by $60K. That means that the house is worth $160K and I owe $60K. A bank might allow me to owe up to $120K in first mortgage debt (75% of $160K). If I have good a good credit rating and a solid income, I might qualify for a line of credit of $60K ($120K minus $60K owing on my original mortgage).

With $60K, I could buy a $160K investment property with a 25% downpayment ($40K). I would keep the other $20K available on the line of credit to cover any emergency repairs or mortgage payments during vacancies. This way, expenses that can be treated as tax-deductable for the purposes of investment property can all be kept in the same account.

It's important to keep in mind that as you use your available secured line of credit, the equity in your house decreases. You should think of your mortgage as being the total of any original mortgage plus any secured line of credit balances.

How Do I Use a Line of Credit After the Downpayment?

I also use a line of credit that requires only interest payments each month. Since the interest is tax-deductable and princpipal repayments aren't, this is actually to the investor's benefit. If you're really lucky, or make it clear to your mortgage broker, you might find a line of credit that allows you to automatically capitalize interest payments.

What that means for me, as a landlord, is that if rent payments are late, or there are vacancies, then mortgage payments, taxes and everything else can be covered on the line of credit, plus the interest payment on the line of credit gets added back onto the principal amount. So, if the rent cheques don't get deposited by the day the interest is due on the line of credit, the balance goes up for a few days. Then, when rent cheques are deposited, the balance goes back down to cover the related expenses.

Investments Shouldn't Adversely Affect Your Monthly Cashflow

So, with the right structured line of credit, I can ensure that my investment related expenses don't impact my day-to-day cashflow. The way I look at it is, any money that a bank would loan me for investment purposes is money I should have working for me instead of being worried about getting my home mortgage paid off.

The banks actually like this setup because they get more opportunities to collect interest from you while you are accumulating net worth with leveraged assets.

... Scott

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