Creative Finance For Real Estate Investing

“I’d love to invest in real estate, but most of my net worth is tied up in home equity and my 401k, which I can’t touch until I’m 59.5.”

Does this describe you? Well don’t give up your investment dreams in favor of couch time and cable news just yet!

You might be able to utilize both your home equity and 401k balance to help fund a real estate deal!

Of course, you should simultaneously address the bigger issue of why you don’t have any liquid money to invest. I recommend an aggressive program of cost cutting and saving.

As you are getting your savings rate up, you might be able to take a shortcut into your investing journey using something called “creative finance”.

Creative finance just means using methods to finance a real estate deal other than a traditional mortgage or commercial loan.

Bigger Pockets has a ton of great information on ways to creatively finance real estate deals.

For this post I’m going to focus on the 3 methods that I have personally used:

1. Home Equity Line of Credit (HELOC)
2. 401k Loan
3. Owner Financing

Home Equity Line of Credit (HELOC)

If you’ve paid down a significant chunk of the mortgage on your house, or if you have been lucky enough to experience some home appreciation, you may have a sizable chunk of money stuck as “equity” in your home.

This equity looks nice on your net worth statement, but it isn’t doing you very much good just sitting there. You aren’t earning any return on it.

“Wait a sec Mr. DS. I am too earning a return! My home value has gone up by a lot over the last few years!”

While you can certainly earn a return on owning a house in the form of appreciation, you will get that same appreciation whether you have $100,000 in equity, or $1,000 in equity. If your house goes up another $5,000 next year, you get that additional equity regardless of how much other equity you have in your house. Wouldn’t you rather earn $5,000 on $1,000 invested than on $100,000?

“OK, so the money that is already sitting there as equity isn’t earning anything. Got it. What’s the use worrying about that though? It’s stuck in my house and I can’t do anything with it, right?”

Wrong! It is actually very easy to secure a HELOC through just about any bank or credit union. They will loan you money secured against this equity in your home. This has the effect of pulling equity out of your home.

“Woohoo! Free money! I’m off to Vegas baby, yeah!”

Hold up there cowboy! This money isn’t free. Just like with your primary mortgage you have to pay interest on it. It is very DUMB to pull this money out and blow it on anything other than an income producing asset.

The Right Way to Use a HELOC for Real Estate Investing

First, go talk to a few banks and see what terms you can get. Shop around, as some banks will have better terms than others. The credit union that I used for my original HELOC only offered a variable rate loan. As rates have risen lately so have my interest payments. I talked to another bank and they gave me a much better interest rate AND the rate is fixed!

Once you get the HELOC set up you will not need to start paying interest right away. It’s kind of like a credit card in that you only need to pay interest on the amount you draw from it. So get it set up and then take your time finding a good deal. Speaking of deals…

Make sure you only use a HELOC (or any other loan) to buy a good deal! This can’t be overstated. By good I mean a rental that will pay for it’s own short and long term expenses (you are saving for a new roof, right?), AND pay the loan service on all loans including the HELOC, AND cash flow on top of that. Remember, cash flow is your safety net!

Since the HELOC is tied to your home and not the rental property, most banks are fine with you using this as all or part of your down payment to secure a conventional loan on the rental property. It’s a pretty sweet deal!

On the cash flow side, since you bought a good property, your tenants will pay the HELOC interest for you (thanks tenants!). All extra cash flow that comes in can get put straight back to paying down the HELOC.

Also, since the HELOC is liquid (you can draw your money back out at any time), you might consider dumping a large part of your emergency fund into paying the HELOC down. If the proverbial shit hits the fan, you still have access to your money, but in the mean time you don’t need to keep a large pile of cash sitting there earning nothing. Mister Money Mustache refers to this as using springy debt in lieu of a cash cushion. Being able to earn a guaranteed return equal to your HELOC interest on your emergency fund and still have the money liquid is a nice perk to the HELOC!

“Wow this HELOC thing sounds sweet! But it doesn’t quite get me to the down payment I need for my next deal…”

Fear not! The HELOC isn’t the only trick up our sleeves…

401K Loan

The HELOC seems to be a widely accepted, and frankly not very creative, form of creative finance. The same cannot be said for the 401k Loan. Bring up this topic and most people will tell you that you are crazy.

The reason that most people get so worked up about this loan product is that there are a lot more moving pieces, and a lot more ways that you can get burned. You have to be careful with this one.

Before I dive into the problems with a 401k loan (and how you can mitigate them), let me start with what a 401k loan is:

When you take out a 401k loan, you are effectively loaning yourself money. You would get hit with a nasty 10% penalty (plus income tax) if you just withdrew the funds from your 401k. However, since your 401k is allowed to invest, it can invest in a loan to you. Your 401k makes a return equal to the interest on the loan, and you pay the interest just like you would if you borrowed the money from someone else.

In this way you can access the money in your 401k without “withdrawing” it and incurring the penalty and taxes.

“Wait, you mean I am paying the interest to myself??? This sounds awesome! That’s kind of like getting a 0% loan!”

Well, not exactly. There are several strings attached.

Opportunity Cost

If you withdraw that money it turns to cash and stops earning you the return you would be getting if it were invested in a low cost index fund (you are investing your retirement accounts in low cost index funds, right?). This is called “opportunity cost”. You are losing out on the money it would have earned.

This problem is easily mitigated. You didn’t take this money out to go on a cruise or remodel the kitchen, you took it out buy an income producing asset! You are trading 1 return for another.

There is another clever way to mitigate the opportunity cost. If your portfolio happens to contain some percentage of its value in bonds, you can adjust your allocation so that the loan you take comes only from the bond portion. This loan is effectively the same as a bond, but probably with a better return (my 401k loan was at 5%, much better than the 2-3% return I was getting with my bond index fund).

For example, if you had a $100,000 401k balance that was 75% stock and 25% bonds, and you wanted a $20,000 loan, you would adjust the allocations so that after the loan you had $75,000 in stock, $5,000 in bonds, and a $20,000 loan outstanding.

Thus you aren’t losing any return from the stock portion of your portfolio (it hasn’t changed), and the bond portion is getting an even better return than it would have! Meanwhile you got a loan that you would have been happy to get from anyone since the real estate deal you used it for was so good (cash flowing, remember?)! Win Win!

You’re Fired!

All of the above sounds great, but I still haven’t hit on the biggest risk of the 401k loan. If you leave your job for any reason (quit, get fired, laid off, etc), the entire balance of the loan is due within 60 days!!! If you don’t pay then it will be treated like an early withdrawal: You will owe income tax + a 10% penalty on the balance of the loan.

Yikes! I hope you’re not reading this blog at work, or if you are I hope your boss doesn’t see!

“Holy crap, that’s scary! Maybe this loan isn’t so good after all…”

It IS scary. Fortunately there are some things you can do to mitigate your worries…

Hold a cash cushion large enough to pay the loan off. This is kind of dumb. If you have the cash to pay it off, why do you have the loan in the first place???

Leave enough room in your HELOC to pay it off. You are on to something here. Just like above, if you had the room in your HELOC to NOT take the 401k loan, that would be the better move. But if you were almost there with the HELOC and will have that space built up in a month or 2 of rental income, then the 401k loan could be a good way to cover this gap.

Rack up enough vacation time to pay it off.

This is what I did.

My work happens to allow employees to accrue vacation time indefinitely. When someone leaves the company, they get paid for all of their unused vacation time. We also have comp time, which allows employees to use any overtime hours worked as extra vacation time.

I’ve mostly used my comp time to take time off over the years, so my vacation time has built up to a very large amount!

In fact, I had enough vacation time to cover the full balance of my 401k loan if I ever left my job or got fired. I was effectively insured against job loss!

…Or just don’t get fired and pay it off as quick as you can!

Using a 401k loan without a means to pay it back in full within 2 months of job loss is a dangerous game. It’s not for me. That said, I’m not here to lecture you on what risks you should or shouldn’t take. I am here to hopefully help you understand those risks so you don’t stumble in blind.

Interest is NOT Tax Deductible

Another disadvantage to the 401k loan as compared to just about any other loan product is that it is not tax deductible.

*Note: I’m not an accountant. Below is just my understanding. Please double check with your accountant, or get a copy of the tax code and read it. 🙂

The HELOC interest is tax deductible on the personal side. Assuming you bought your property through a business, the mortgage or commercial loan interest is deductible on the business side. Getting deductions on the business side is even better because you get them even if you’re under the standard deduction on the personal side.

The 401k loan is just a personal loan to you. Not deductible. The fact that you then turn around and contributed this money to your business so you can purchase a property doesn’t change the fact that the loan and interest are in your name.

Seller Financing

Seller financing occurs when the seller of the property acts like the bank and lends you all or some of the money to make the purchase.

From a buyers perspective this is nice because there are no closing costs like there would be at a bank, and the terms are usually more negotiable.

From the sellers perspective this can be nice for several reasons:

• You don’t have to worry right away about how to invest a large lump sum amount of cash. You keep it invested and earning a return.
• You maintain some monthly cash flow in the form of loan payments without the hassle of managing a rental property.
• If the property is hard to finance through banks for some reason (mobile home parks, for example), then you increase the amount of potential buyers by taking the financing hurdle off the table.

As a buyer, there is really only 1 major downside to seller financing: You don’t know whether the loan is possible (or the terms), before starting your property search.

The previous two types of creative financing, and conventional mortgages or commercial loans, are things that you can figure out before you look for a deal. This is great because then you know your parameters and can better filter your property searches. With seller financing you can’t know the terms, or even whether it’s available, until you find a deal and talk to the seller. Thus, relying on seller financing from the start as your only form of financing makes the search phase more difficult.

How do you get seller financing? If you find a property that you want, at a price that makes the numbers work, just ask. The worst the seller can say is “no”.

Putting It All Together

There are a ton of ways you can combine the above financing techniques to make a real estate deal work. To give you an example, I will talk about the first property that I bought and how those numbers worked.

Property Purchase: 12 Unit Mobile Home Park

• The Deal:
  • Purchase Price = $345,000.
  • Lot rent (at time of purchase) = $395/month
  • Gross annual rent = $395 x 12 units x 12 months = $56,880
  • Net Operating Income (NOI) assuming 40% expense ratio (pretty close to how actual expenses turned out) = (1-0.40)*$56,880 = $34,128 –> $2844/month
  • Cap Rate = $34,128/$345,000 = 9.9%
  • Commercial Loan Rate = 5% –> 4.9% Spread! (I like to aim for at least a 3% spread)

There was 1 significant issue with the park: 1 bad tenant in a really crappy mobile home that needed to be replaced. I was able to turn that into a value-add, but I’ll leave that story out for brevity-sake.

I thought this was a pretty good deal! Now all I had to do was get the financing to work and make sure it actually would cash flow.

• The Financing:
  • ~67% L/V Commercial Loan
    • Amount ~ $230,000
    • Terms ~ 15 year loan with no balloon at ~ 5% interest
    • Payment = $1,827/month
  • HELOC
    • $111,000 available to pull.
    • Used ~ $100,000 towards the purchase. The remainder stayed unused as “emergency capital”
    • Variable rate interest at ~4% at time of purchase (this recently climbed to ~6.5% at which point I refinanced to a fixed rate 5% loan at a different bank).
    • Initial monthly interest payment ~ $333/month
  • 401K Loan
    • Pulled out $18,000
    • 4% Interest paid to my 401k
    • 5 year loan (that was the longest available)
    • Monthly payment ~ $330
  • I put no cash into the actual purchase, but did contribute $10,000 to start a business checking account to serve as an operating fund.
  • Cash Flow = $2,844-$1,827-$333-$330 = $354/month
    • Cash on cash return = $354*12/$10,000 = 42% (!!!)
    • The actual return is higher, since in addition to the cash flow the rental income was paying down the loans.
    • I paid down the 401k loan in a few months, at which point the cash flow increased by $330 (nearly double)!

As you can see, I was fortunate enough to find a smoking good deal! However, this would not have been possible without creative financing. I simply did not have the $128,000 ($118,000 for the down payment plus $10,000 starter money for the operating account) sitting there ready to deploy. This is the power of creative financing.

Hopefully this shows you that there is more than 1 way to skin a cat. If it’s a good deal, don’t give up just because the financing will be tricky. Instead, figure it out!

As Robert Kiyosaki said (paraphrased): Don’t say, “I can’t afford it.” Instead, ask yourself, “How can I afford it?“