“Buying a home is usually a wise financial decision because it allows you to invest your hard-earned income in a real asset that builds equity.” – Lamar S. Smith
SC, a good friend, has been reading what I’ve been saying in Automatic Wealth about investing in real estate. This morning, he e-mailed me with this question:
“We don’t have any substantial ‘liquid’ assets. So, does it make any sense to invest in real estate by borrowing funds from the equity in one’s own home? If rental income can cover the loan payments, it seems to me it could work. What do you think?”
My initial impulse was to tell SC, “Yes. I’d do it if rental income covered not just the payments on the home equity loan, but also all the expenses of the rental property (including mortgage, insurance, maintenance, management, and taxes). You don’t want to be cash negative on an investment in this market.”
But before saying anything to SC, I checked with Justin Ford, ETR’s resident real estate expert and editor of Main Street Millionaire.He agreed with my thinking.
Here’s what he said: “Is it a good idea to use the equity in your home to buy investment property? Absolutely. I’ve done it.
“You’re not spending your home equity … you’re putting it to work. A property that pays for your home equity loan as well as all its own costs can make excellent sense – if you buy right.
“Here’s how it works: “You have $100k in equity in your house. It’s going up 6% a year. Just leave it in the house, and you’ve got $106k in equity after one year.
“Instead, you tap the home with a home equity line of credit (HELOC) for $85k. You split that up into three $25,000 chunks of money and use them as 10% down payments for three $250,000 investment properties. The other $10,000 is for closing costs.
“You now have a loan payment on your house that you didn’t have before. Let’s say that loan is costing you 6% on a 30-year amortization schedule. The $85k will then cost you about $510 a month.
“But you bought your investment properties right. So all of those properties will pay for their 90% mortgages, their taxes and insurance, and provide an allowance for vacancy and maintenance. Each one also kicks off, say, an extra $250 a month. That’s $750 a month total. That $750 extra covers your $510 on your HELOC and gives you $240 in net monthly income.
“But now, instead of owning a single $100k property that appreciates at 6% a year … you own $850,000 worth of property that appreciates at 6% a year. (That’s your $100k home plus the $750k in investment properties.) So instead of gaining just $6k in capital appreciation, you gain $51,000 (6% of $850,000). Plus, you pick up almost $3,000 in net income. Plus, you pick up some more equity in amortization (the reduction of your loan balance) – maybe $7,000, or around 1% of your original loan balances.
“If you didn’t take advantage of the HELOC to do this, here’s what your balance sheet would look like … Total Net Assets: House = $100k
“But if you did the HELOC, here’s how your balance sheet would change … Net Assets: House = $15k ($100k value minus $85k HELOC) Investment Properties = $75k ($750k investment properties less $675k mortgage with 90% financing) Total Net Assets = $90k
“INITIALLY, $10k is eaten up in transaction costs, so your net temporarily dips. But here’s what happens after a year if you didn’t do the deal … Total Net Assets After a Year: House = $106k
“And here’s what happens if you did the deal … Net Assets: House = $22k ($106k market value minus $84k HELOC; $85k loan has amortized by $1k) Investment Properties = $133k ($801k value, after 6% rise, less $668k loan balance; loans have amortized from $675k to $668k) Cash in Bank from Net Income on Investment Properties = $3k Total Net Assets = $158k
“So, you’ve increased your equity by $52k this way … without increasing your net monthly payments. In fact, you’re now earning passive income too. And that income should grow over the years, as net rents tend to rise. But none of this can happen unless you learn how to buy right first. That’s the key to making good money in any real estate market.”
This year, at our Wealth Building Conference, I’m going to introduce the subject of the book I’m writing now: “Seven Years to Seven Figures.” In my presentation, I’ll show how investors who want to become financially independent relatively quickly almost have to get involved in real estate.
Justin’s example above proves the point: With the leverage you get from mortgaging property and the safety you can build into the investment by “buying right,” real estate is still a great way to build wealth – even in today’s overheated economy.
editor’s note.[Ed. Note: Mark Morgan Ford was the creator of Early To Rise. In 2011, Mark retired from ETR and now writes the Palm Beach Letter. His advice, in our opinion, continues to get better and better with every essay, particularly in the controversial ones we have shared today. We encourage you to read everything you can that has been written by Mark.]