Understanding the Role of HELOCs in Portfolio Diversification and Capital Structure

Home equity line of credit, or HELOC, is a popular form of financial assistance that can help individuals fulfill different types of financial requirements. For example, people may use a HELOC loan to fund educational expenses, pay for home renovations and repairs. Moreover, they may use the funds to cover medical costs or any major expense.

While these are some common use cases of a HELOC for homeowners, people are using it strategically to improve investment planning. Moreover, it can play a key role in strengthening the capital structure of a business. If you are looking to understand the importance of a home equity line of credit in these areas, you have come to the right place. 

In this article, we will take a look at the significance of HELOCs in portfolio diversification and their influence on capital structure strategy. Moreover, we will explore the benefits and limitations of utilizing HELOCs in investments concerning real estate.

Having said that, before we dive into the above aspects, first, let’s understand the meaning of a home equity line of credit and how it works. 

A HELOC refers to a revolving credit line that allows borrowers to get access to financial assistance up to a prespecified limit. The amount of credit individuals can access depends on their home’s value and the outstanding balance on their mortgage. In other words, it is a type of secured loan where one gets access to funds by utilizing their home as collateral.

The collateral provides confidence to the loan provider that they will be able to recover the amount provided as credit to the borrower. Moreover, since this is a type of secured loan, individuals can find it easier to fulfill the lender’s eligibility criteria, and the cost of borrowing is also low. 

To develop a better understanding, one can think of a HELOC as a credit card. Individuals can access a predetermined credit limit, and they can borrow funds when and if required. Interest is only chargeable on the amount borrowers utilize. On account of the flexibility, HELOCs are a favorable option for homeowners seeking funds. 

By availing of a HELOC, one can get access to funds and use them to invest in multiple asset classes and subclasses. This can help build a diversified portfolio comprising different financial instruments, like stocks, bonds, etc., which, in turn, can play a crucial role in portfolio risk management. Indeed, by utilizing the funds to invest in different avenues, individuals can avoid relying on a single type of asset and spread their investment across different markets and asset classes to increase the possibility of reaching their financial goals. 

Individuals can choose the assets to invest in based on their investment horizon. Also, note that one can use a HELOC to improve their liquidity position. This is because by using the funds received, they can avoid tying up their capital in only their home.

Once individuals understand the role of HELOCs in portfolio diversification, they can explore the effects on capital structure provided in the next section.

As noted above, HELOCs have a low cost of borrowing since they are secured loans. Thus, for companies, this type of financial assistance can lower the overall cost of capital. In addition, one can get access to funds quickly if they apply for HELOCs. As a result, they can alter their liquidity position quickly with this type of credit. This feature also helps companies improve their cash flow management. 

The flexibility offered by HELOCs can also help a company enhance its debt-to-equity ratio, which is a key metric for stakeholders. Indeed, the flexible repayment terms associated with HELOCs can allow businesses to cover expenses and invest in growth without giving up equity. Having said that, HELOCs come with variable interest rates, which can expose businesses to interest rate risk. Hence, it is vital that companies use them wisely to avoid impacting financial stability. 

There are some advantages and disadvantages of utilizing HELOCs for investments in real estate. Let us look at them.

Advantages

• No End-use Restrictions: This type of credit can be used for different purposes, as it typically does not come with any end-use limitations. So. Individuals can use the funds to renovate their existing real estate properties or purchase another asset to enhance their portfolio value 
• Tax Deduction: The interest paid by a borrower on a HELOC might be eligible for tax deduction. That said, it depends on the rules and regulations that are applicable. 
• Low Interest Rate: The interest rate payable on such a loan is generally low because of the collateral involved. Hence, one can use such a loan to make a down payment. It is a cheaper option when compared to unsecured loans, for example, personal loans.
• Revolving Credit: Once individuals repay the amount borrowed, they become eligible to borrow those funds again. Hence, post-repayment, they can use the money again for further investments. 

Risks

• Variable Rate Of Interest: As noted above, these loans come with a variable rate of interest. Thus, in the case of a rising interest rate regime, borrowers have to pay a higher interest rate. 
• Unfavorable Economic Conditions: Unfavorable economic scenarios, for example, economic downturns, can result in a decrease in capital appreciation and lower rental income. These factors can have a significant impact on the borrower’s repayment capacity.
• Loss Of Property: In the case of a default concerning a HELOC, the lender has the right to seize the property that the borrower provided as collateral.

In this section, let us check out the best practices with regard to using HELOC for investments. 

• Limit The Draws: Individuals or companies should consider drawing funds only if required when investing. Although HELOCS provide the flexibility of drawing money when required, borrowing beyond the repayment capacity can lead to a debt burden. 
• Clearly Define The Goals: Borrowers must set the investment goals that they want to achieve using a HELOC. Not setting objectives can lead to unplanned borrowed, which can lead to financial strain in the future. 
• Diversify: One must use the funds to diversify their portfolio to maximize gains and minimize risk exposure. If investors do not understand the importance of HELOCs in portfolio diversification, they will miss out on a key benefit.
• Track Interest Rates: As mentioned earlier, a home equity line of credit does not have a fixed rate of interest. Hence, it is vital that individuals assess the market conditions and factor in possible interest rate changes before taking on debt for making investments. 
• Cash Flow And Repayment Alignment: Businesses must make sure that the repayment schedule concerning HELOCS is in line with their cash flows to avoid a cash crunch and ensure a stable liquidity position. 

Now that we are at the end of the article, we hope the role of HELOC in portfolio diversification and its potential impact on capital efficiency are clear. Only when one has a clear understanding can they use it strategically for their benefit. With a prudent approach, one can enhance their portfolio returns, reduce risk exposure, management cash flow, and improve their overall financial position efficiently.