A couple months ago, I was presented with an opportunity I had not planned on when I initially formed my wealth building plan. I bought a new house using a little bit of creative financing. While we got a classic 25% down, 30-year mortgage, we opened a HELOC and borrowed an additional 15%, allowing us to reduce the amount of capital outlay.
This was all designed to let us sell the old house after we moved and minimize the amount of cash we needed to transition. But it opened the door to another wealth building opportunity. On one hand, I had an interest-only loan at 4%. On the other hand, I had a big check from the sale of our old house.
In classic money management, the natural approach would be to simply pay off the HELOC. But there are other options out there. I had already done the leg work of researching stocks, real estate, and some other things. One of the stocks I have a position in has been paying consistent, increasing dividends for over five years. It’s an MLP which meant that it has to pay over 90% of its revenues to stock holders resulting in a high yield around 8.5%.
The opportunity was to make money the old fashioned way: arbitrage. Banks borrow money at one rate and then loan it out to consumers at a higher rate, making money off the difference. We can do the same. In this case, I had a lump sum loaned out to me at 4%, interest-only and could increase my position in VNR that would pay me 8.5% on a monthly basis. Each month, I can take every dollar of dividend and put it towards the HELOC, slowly paying off the balance of the loan. Eventually, I would pay off the HELOC and be left with a nice investment in a well paying stock!
To make wealth building decisions, we need to identify and weigh the risks. We also need an exit strategy. Essentially, we need to be ready to handle things if the risk actually kicks in. So let’s list them out and see if we can spot a way to mitigate each one.
- HELOC interest rates rise
Right now, the gap between the HELOC and the stock is over 4.5%. If the HELOC rises 2-3%, there is still a profitable margin. Even if the HELOC rises 5% and somehow the stock does NOT increase payouts (like they have for the past five years), I don’t have to panic. That probably wouldn’t happen overnight, and it would still be possible to sell the stock position and immediately pay off the HELOC. I would have still made money.
This is definitely a risk when buying any stock. Stocks are driven by logical circumstances, but they are also driven by irrational behaviors as well. The key is to not get swept up into day trading and instead look at the big, long-term picture. In our situation, it’s important to realize that dividend yield is the critical value of buying more VNR, not appreciation. We aren’t monitoring the stock for appreciation, but instead seeing that it keeps up its dividend payoffs. If the stock price plummets, we need to watch it and see if dividend payouts are being threatened, or if instead, it presents us with an opportunity to buy a bigger position. After all, one man’s panic is another man’s opportunity
. If we keep getting the same dividend, then we can stay put and continue building wealth.
- Dividend payouts fundamentally change
The key part of this wealth building activity is to get regular dividend payouts that far exceed the cost of the HELOC. If the board of VNR stops making dividend payments or severely cuts their payouts, a serious reevaluation must be made. Some of our options on the table include selling the stock position and moving the money into a competitor. It’s a valuable reason to research VNR’s competitors, and there are many. That means that this wealth building activity doesn’t have to wrap up with paying off the HELOC.
If all of these risks materialize at once, what then? No doubt we’d be in the middle of a a catastrophe! What then? First of all, we must recognize it’s a highly unlikely situation. Even so, what would we do? Simply put, if the stock position drops and dividend payouts cease, then we can no longer continue our original plan of using the stock pay off the HELOC. Time to get out.
I have liquid cash as well as multiple investment properties. I could refi or sell a property and pay off the remaining balance of the HELOC. Or by that time, I might have another investment vehicle in motion that could take over paying off the HELOC. Any way this goes down, if this tragic change were to happen five years from now, we would have definitely accumulated more wealth. What’s critical is having the research, options, and ability to seize this opportunity that fell out of the sky, and then actively tracking our progress.
So we’ve viewed the risks and weighed them accordingly. What rewards does this present us with?
- By seizing the HELOC money and investing it into an MLP stock, we might eventually pay off the HELOC and continue receiving the dividend payouts.
By building up a position in a tax advantaged stock like VNR
, we can continue to pipe that dividend payout into other opportunities, like paying off real estate investment loans. We could buy more VNR and increase our position. We can also use it to buy up an alternative like BRK-B
- VNR continues to increase their dividend payouts.
Right now, the payout is about 8.5%, which is already pretty good. Maybe that sounds like peanuts because you’re financial advisor promised 12%. But let’s assume VNR continues its trend of increasing payouts. It’s possible I could be receiving 15% sometime in the future, perhaps after paying off the HELOC. Or maybe the increases come sooner and help me pay off this fixed debt faster. That would be great! It’s one of the reasons for investing in stocks that have a history of increasing dividends.
- MLPs weather inflation pretty well.
MLPs by definition are involved in storage, transportation, and delivery of natural resources like oil and gas. Those commodities tend to increase in value with inflation. Their stocks do as well. That means as inflation rises, the chances that our stock value and dividend payments would rise is pretty good. It might not happen at the exact same moment, but in general these markets travel together. That makes this a good long term investment.
- Every dollars invested in paying off the HELOC is another dollar in our pocket
The HELOC gave us the opportunity to build some cash. Every dollar of dividend that goes towards the HELOC reduces our total liability. It also slowly reduces the monthly amount of interest we owe.
Would you really borrow money to buy some stock?
I hear this question often on radio shows and in blog articles. People have a life altering event that suddenly drops a big wad of cash in their lap. For example, a loved one passes away and they get an insurance payout. Or sometimes they got some big severance check and find another job. They call into these radio shows and want to know what to do with all this money.
The fact that they are calling into the shows is a strong indicator that they don’t have a well developed wealth building plan. The tone of the callers often indicates they haven’t really learned about stocks vs. real estate vs. EIULs vs. other options to build wealth. Instead, it seems like they either have some mutual funds or nothing. I don’t hear much else, except the rare instance of a perhaps living in one side of a duplex and renting out the other side.
The host often tells them to go nuke the mortgage on their house. Sometimes you hear doubt in the caller’s voice. Some even ask, “But I could invest it, right?” To me, it sounds like a glimmer of hope that they could make some money. Why? Because silently, they know their current plan isn’t working. The followup from the host is usually what’s meant to be a softball question, “Would you walk down to your nearest bank and borrow that money to invest it?” The caller always answers “heck no!”
If someone asked me the same question, I would answer a resounding “yes!” If given the opportunity to borrow at 4% interest-only and invest in something with a steady payback of 8.5%, then I would definitely make a profit! But most people haven’t spent any time actively putting together a wealth building plan, so when these life changing events happen, they aren’t prepared to seize the opportunity. Are you? If you’re not sure, contact me
and we can talk about it.