A house can also be a wealth-building asset—if you know how to leverage your equity properly. It can also be a wealth-building asset for many.
Home equity is simply how much of your property you own, i.e. how much you’ve paid for versus how much mortgage is left to pay off.For instance, if your property is worth $200,000, and you have $150,000 left on your mortgage, your home equity is $50,000.
When you borrow against your home equity, your property becomes collateral. In return, you get lower interest rates as opposed to, for example, those of credit cards. The obvious risk is losing your house if you are unable to make the payments, but this risk can be mitigated if you are careful about your finances and make wise decisions that are right for your personal circumstances.
The word “debt” usually carries with it negative connotations, but acquiring it can be a great leg up on increasing your personal wealth, often at a much faster rate than if you were to just do it by saving up. When investing, you can put to work either your own money—which might affect your cash flow and make immediate needs impossible or difficult to fulfill—or other people’s money. The second scenario is essentially what it means to leverage your home equity.
There are two ways lenders will allow you to borrow using your house as collateral. One is through a fixed-term home equity loan and the other through a home equity line of credit (HELOC). In a home equity loan, a lump sum is released to the borrower. Payments are amortized over a set period of time. On the other hand, a HELOC is much like a credit card that allows you to withdraw any amount within the credit limit and period of validity. It allows you a lot of flexibility because paying off the principal frees up your available credit. If your maximum line of credit, for example, is $20,000, and you pay off $5,000 of the $10,000 that you’ve borrowed, then your available credit becomes $15,000 ($20,000 – $10,000 + $5,000 = $15,000).
According to the Financial Consumer Agency of Canada, HELOCs are second only to mortgages as the largest contributor to the growth of household debt, thanks to their accessibility and flexibility. While this is not necessarily a bad thing, we need to look at some facts.
49% of borrowers spent their debt on renovations, 22% on debt consolidation, 19% on the purchase of a vehicle, 19% on daily expenses, and 13% on vacations. Only 11% used their HELOCs to acquire residential properties and make financial investments.
36% of HELOC borrowers aged 25-34 used their loans to pay off other debts. Initially, this seems to make sense, as it is essentially replacing those debts with one that has lower interest rates. However, is this the most efficient use of a loan?
But where do you put that money, and how do you manage the risks? Here are some ideas.
Renovations. Renovations, which account for the lion’s share of loan spending, may actually be a wise investment if the homeowner plans to sell the property at some point. Depending on the location and the real estate trends there, renovations can increase the value of the property.
Stock market. Purchasing stocks is known to be high risk, but a quote from Investopedia is worth mentioning: “There are no perfect definitions or measurements of risk.” Market volatility is definitely a concern, but some stocks carry more risk than others. This will depend on many factors like industry sector, economic trends, and the company’s history and profile. When investing in stocks, the first thing one must take into consideration is the expected returns versus the cost of acquiring the debt used to pay for them.
Business. Many entrepreneurs make the mistake of putting their business expenditures on credit cards. The high-interest rates can be fatal to an enterprise; when the company hits a downturn, which is common for any business, those debts can balloon faster than people realize. Borrowing against one’s house is a cheaper way to start a business or fund its expansion.
Education. When making the decision to pursue further studies, you must ask yourself whether or not education is a good investment that can realistically benefit you financially in the long run. One thing to note is that education is something that, unlike a house, cannot be foreclosed or taken away from you, but that is not to say that a diploma will automatically increase your wealth either.
Investment property. Some will opt to make another real estate investment using their existing homes as leverage. A residential, commercial, or retail property can be rented out and turned into self-liquidating assets.
Risk is, of course, a cause for concern, and putting all your eggs in one basket, while it may yield high returns, can also prove financially disastrous. Diversification is a great way to spread out these risks over multiple investments.
There isn’t a single type of investment that is right for everybody. It will depend on your personal circumstances, existing assets, and tolerance for risk. The bottom line is that one should treat debt as a way to increase one’s personal wealth, and not as a means to instant gratification.
If you are a first time home buyer, or an investor, reach out to H. Jaggi homes. We will make your process easy to navigate and answer all your questions in this journey. As a team of experienced realtors, we can help you get into home ownership or start your road to real estate investing! It is easier than you think!