I once used a promotional “zero-percent-interest-and-zero-points” cash advance feature on my $25,000-limit credit card to buy a $25,000 property. Then, I refinanced it with a local community bank at 100 percent loan-to-cost (75 percent loan-to-appraised- value) within six months, right before the initial interest free period expired. That credit card line of credit allowed me to purchase a property, have it fixed up and rented, and mortgage it with a long-term loan without my actually having $25,000 in cash on hand.
This makes credit cards and real estate sound like a great combination, right? Yes, it does. But you must understand everything about your personal credit situation and the deal you are going to do using that credit to leverage this strategy successfully. First, understand your options:
1| Lines of Credit
A line of credit is simply a maximum loan amount that a lender has committed to a borrower over a specified period. The borrower can usually access the loan amount repeatedly during that time as long as the borrowed funds are repaid according to the terms of the loan agreement. For example, if I have a line of credit of $50,000, use all of it, and then repay $23,000, I can borrow up to $23,000 again if I need it as long as I’m in good standing with the lender.
Because lines of credit are very flexible and beneficial for borrowers, lenders usually require that these loans are short-term in duration. However, it is good news for borrowers that lenders almost always renew the lines at maturity of the loan if the borrower has upheld their end of the bargain.
2| Credit Cards
Credit cards are issued by a financial company and give the borrower an option to borrow funds up to a maximum amount determined by the credit card company based on credit scores, income, and payment history.
3| Home Equity Line of Credit (HELOC)
A HELOC is a second mortgage on personal residences that offer access to the owner’s equity in the home.
4| Personal Unsecured Lines
These lines of credit are similar to credit cards and usually offered to highly creditworthy individuals by retail and commercial banks. Most people who obtain these lines have some combination of excellent credit scores, a long personal history with the lending institution, extremely low or no personal debt, and a high net worth.
5| Cash-Secured Lines
A cash-secured line is similar to a personal unsecured line except a borrower has to put up a cash account, usually dollar for dollar, at a financial institution as collateral. For example, with a $50,000 certificate of deposit (CD), a bank would give a customer a $50,000 line of credit secured by the CD.
6| Marketable Securities Pledged Lines
This type of credit line is essentially the same as a cash-secured line except the collateral is in the form of stocks or bonds. Unlike a cash-secured line, which is 100 percent loan-to-value, these lines are approximately 50-cents on- the-dollar because securities fluctuate in value so frequently.
Conventional wisdom (and a lot of financial-help gurus) advise real estate investors to steer clear of using credit. They warn that you might end up over your head in debt. However, if you are responsible and strategic with your credit lines, you can experience great success. In my experience, investors derive two major benefits from having a line of credit:
Benefit #1 – Quick Cash
A line of credit serves as “dry powder.” The old saying that “cash is king” is still alive and well in real estate investing. Having a line of credit allows an investor to offer sellers a quick cash close, which frequently lands the deal (compared to financing a purchase through conventional borrowing, which can take months to complete).
Benefit #2 – Free and Clear Property
Using a line of credit allows an investor to purchase a property without a mortgage, since the line of credit is usually secured by another underlying asset. This is a benefit because the property purchased on a line of credit is owned “free and clear” of a mortgage, which allows the property to be easily sold or financed at a future date.
Using Credit Responsibly Includes Knowing the Disadvantages
Although there are many reasons to use a line of credit, there are a few disadvantages. First of all, when you use a line of credit, you have to pay interest. That adds to the total cost of the property. Be sure to factor in the cost of interest in a worst-case scenario when you are deciding whether to use credit to do a deal. Remember, nothing is 100-percent predictable, and you need to have a strategy for dealing with unexpected delays and the associated interest.
For example, in my opening case study, I had several alternative plans ready in case I was not able to obtain that long-term mortgage. First, I would have started paying the interest due every month on the credit card, leaving the principal balance outstanding. Second, I would have made additional monthly payments to reduce the principal while continuing to look for a permanent mortgage for the property. In a worst-case scenario, I would have attempted to sell the property for at least what I owed on the card. None of these alternatives would have been my ideal, but I had several options and was prepared to exercise them.
Fortunately, I correctly evaluated the situation and was able to go with my preferred strategy. Planning is everything.
Second, access to quick cash can cloud your judgment. Sometimes, “easy money” causes investors to over-invest, or put more money into a property than they should. Always be judicious with your spending even if the money is a line of credit rather than your cold, hard cash.
Third, the more credit you use, the less quick capital you will have in the future. This is the definition of opportunity cost. This is not necessarily a disadvantage since it only emphasizes how important it is to use your credit wisely, but it is important to note since the more debt you have (real estate-related or not), the harder it becomes to borrow.
Fourth, using credit requires serious discipline. Since most lenders only require borrowers to pay interest on the line of credit during the term of the loan, it requires unusual discipline to pay down principal on the line of credit before it is due. This can limit an investor’s ability to build up additional equity in a property from principal pay down.
Finally, using credit can get complicated. Although it is unlikely, there is always the chance that a lender will not renew a line of credit when it reaches the end of its term. This is unusual, but it does happen, and it may cause you serious complications if you are actively using a line when it matures. For example, you might be asked to pay the balance in full all at once. Always remain in close contact with your lender and have a clear game plan for handling surprises. It’s clear that using a line of credit can dramatically improve your rate of wealth creation and your ability to invest effectively in real estate.
Savvy investors not only use credit effectively but also build out their credit options. After all, there is no such thing as having too much access to capital. •
Real Life Example
Below is real life example of how one of our clients recently got started in the rental business with a line of credit.
The investor has a $60,000 HELOC, which means a bank has loaned the investor $60,000 secured by a second mortgage on the investor’s personal residence (i.e., the equity in the home).
A few months ago, the investor found a $48,000 property to purchase (see image below). After borrowing the purchase price from the line, the investor used another $10,000 against the line to make repairs to the property. At that point, our client was “all in” at $58,000, but did not owe any money against the investment property since the money was borrowed from the line, which is secured by the investor’s primary residence.
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