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How to Buy a Home or Investment Property | Don't Get Burned!

As I was sitting at my computer desk going over my bills sometime last week, a crazy thought had come to me. The thought came as I looked over the $1,000 that I was paying for rent here in Charlotte, NC, a city in which I probably wouldn’t mind retiring to within the next fifteen years or so. The thought was, “Hey, meathead! What in hell are you scared of? If you have the means, buy a home and have that sucker paid off in fifteen years or less so you can eventually stop shelling out $1,000 a month or more in rent!” A great wake-up call, but I definitely have the answer as to what was I scared of.

MY FIRST HOME TURNED FORCED INVESTMENT PROPERTY

In my book, How We Prevent Wealth, I go into detail on how my first home purchase back in 2007 was the biggest financial hiccup that I’d made to that date. My hiccup didn’t come in the fact that I purchased my home at the top of the housing boom and then subsequently saw my home’s value rapidly decline, it came in the fact that my analysis in purchasing my home was jacked.

In brief, my analysis was as common as the average man’s thought process. The majority of people who purchase homes, just as I did in 2007, try to purchase as much home as they can within the 3o year or longer mortgage that they’re approved for. And if they know, or even think, that they are going to relocate several years after their purchase, their notion is if they can’t sell their home, they’ll just rent it out. What was I thinking? I’m not an average man by any means, I’m an elitist. 🙂

Well, for my first home, which had a purchase price of $193,000, I used a 30 year fixed rate mortgage term at 6.5%, which, by the way, is an extreme way to prevent wealth being as how with this loan type 90% or more of your loan payment goes towards interest.

Case in point:  My mortgage payment on this home is $1225, where in the first few months of the loan only $150 was going towards principal.  After 51 monthly ( a little over 4 years)  on-time payments of $1225 (not including taxes and insurance) to date, totaling $62,475, I still would owe $183,831 had I not made a few extra payments onto my $1225 monthly obligation.

$62,475 paid but there was only a $10,000 decrease in principal balance!

Luckily for me, I made about a total of $9,000 in extra principal payments before my divorce began, so that I only owed around $176,000. But, after making $71,000 in payments, I still owed $176,000 and had 26 more years to pay for a home that, oh, by the way, I would no longer live in. WTF!?

I moved from my home approximately two years after living in it.

When I first purchased my property I just knew that I would rent it out. But I ran into a problem once that time had come.

My total payments, including insurance and taxes came to roughly $1,550 monthly, but the average rent in the neighborhood in which my home is located goes for $1150 monthly, at the high end.

Translation: I began renting out my home for $1,100 monthly, although my total costs were $1550, which meant that I was coming out of pocket by $450 every month just to cover the full mortgage payment.

Of course, some people would argue that I should look at the situation as only paying $450 monthly for a home that will eventually be paid off, but seriously? $450 monthly for the next 26 years is $140,000 worth of payments on a house that was originally $193,000. What sense does this make? The point of a rental property should be to pay nothing more on your home than what your tenants pay so that you can say you didn’t pay a dime over the past 26 years. Ideally, you’ll even want to say you profitted plentiful over the past 26 years.

Anyway, all of this was to state that I should have done a better analysis to hedge against those monthly income losses from this property. My plan for this first home turned investment property is to eventually either sell it or accumulate enough money to re-finance it using a 25% down payment (investment properties required 25% equity) such that it’ll be paid off within the next 15 years.

Update: Since writing this post, I used HARP 2.0 to refinance my rental property with a 4.75%, 30-year mortgage. My current rental income is $1,050 and my total mortgage payment (P,I,T & I) is $1,136. This is much better than “losing” $450 monthly.

MY NEW THOUGHTS ON HOW TO BUY A HOME OR INVESTMENT PROPERTY

Since there are so many people who believe that renting is throwing away money, I decided to write the following guidelines on how to buy a home or investment property so those folks won’t get burned.

After my first home purchase hiccup, I vowed never to make the same mistake twice. I don’t regret purchasing my first home, I only regret my immature analysis that has put me in the situation I’m in now, with respect to that home. In fact, the home is a great rental property in a golf community with a community pool, playground, walking trails, and many other amenities. Also, I’ve been fortunate to have renters whom have never missed a payment. Still, if I were to make another home purchase, I would make the following drastic changes in my analysis:

STEP 1: Find a neighborhood that is maintained really well, preferably with an active Home Owner’s Association.

Some people don’t like paying home owner’s association dues. I know I don’t. The HOA dues at my first home are $845 yearly. But, the advantage of an HOA is, in theory, the association keeps the neighborhood clean and kept nice by enforcing standards such as requiring lawn cutting, prohibiting vehicles from parking on the streets or in grass, or having garbage cans (or garbage for that matter) left in front of one’s house. Furthermore, the association is responsible for the upkeep of the communities’ amenities. In other words, a HOA acts to keep the neighborhood home’s values going up, or at least mitigate a rapid decrease in value of the homes.

STEP 2: Find out what the average rental prices are in the neighborhood, and if possible, try to determine what the turnover ratio is for renters.

Determining the average rental price allows you to see where your mortgage payment should fall at or below, so that if you have to rent your home, you’d do so at a profit or at least a break-even point. It would prevent having a mortgage of $1,550, but only being able to get $1,100 in rent, if that’s the going rate. In theory, if the average rent can not be achieved with a 15 year or less term mortgage, you’d know that you’d have to keep searching in other neighborhoods until you can find the right pricing point. Again, this step hedges your losses in the event that you have to rent your home.  

STEP 3: After accessing the average rental prices in the neighborhood, apply for a mortgage where your total monthly payments will calculate less than the average rental prices in the neighborhood.

The longer the terms of one’s mortgage, the lower the payments. But, the longer the term of one’s mortgage, the more interest is paid over the life of the loan AND the longer it takes to build enough equity to even consider selling the home if the value of the home depreciates. Like I shared in my own personal story, because my first home was purchased with a 30 year mortgage at 6.5%, four years later, I still would owe $184,000 had I not made a few thousand dollars in principal payments. But, with a 15 year mortgage at the same rate (15 year mortgages are generally .25% lower in rate), four years later I would have owed only $160,000 without making extra principal payments–a difference of $24,000–and I would only have 11 vs. 26 more years to pay.

STEP 4: Purchase your home, live in it, but if you have to move, rent it out without one dime leaving your pocket.

If these home buying steps are followed, and one has to relocate, he or she shouldn’t have to sweat over excessive out-of-pocket expenses.  If rent is going for $1,000 and your monthly payments total only $900, how can one lose, assuming the home stays occupied with tenants.

But there is an underlying sacrifice: In a neighborhood with an average rent price of $1,000, the loan amount that one should seek to “fit the bill” should amount to no more than $100,000 on a 15 year fixed rate, or $150,000 on a 30 year fixed rate, which is the killer.

Most people purchase homes with emotions. “Oh, I gotta have it so who cares if my loan is stretched to 30 or even 50 years, and that the price of the home is 10 times what I earn annually.” Well, I care for certain, especially since I have proof that it’s expensive to pay out-of-pocket every month, AND I’m building equity slower than the proverbial tortoise from The Tortoise and the Hare.

In any case, if you don’t believe me, run the numbers using the following calculator on Bankrate’s site: Loan Amortization Calculator. Run a home with a price of, say, $200,000 using a 15 year vs a 30 year mortgage and see what the total difference in costs are.

And if you still don’t believe me, or if I haven’t yet convinced you how not to prevent wealth, then first, read this chapter of my first personal finance book, and then return to this page to leave a comment below.

As far as me, I’m now about to purchase my second home that will be my primary residence here in Charlotte, but will probably eventually become an investment property up until I return to Charlotte to retire. Of course, I will use my steps above. I’m no longer afraid to purchase another home. I just had to wait until I was educated enough to better analyze where I went wrong the first time. However, now, I’m certain that my new plan won’t burn me. 🙂

Update 3/10/14: I’m about to rent my home that I purchased here in Charlotte. My current mortgage is $550 and it will rent for at least $1,050. And to ensure that I have enough money to pay any negative equity just in case the home depreciates, I’ve been saving all the money that I would have paid in rent. I definitely didn’t get burned on this deal.

Comments

  1. Ummm hate to be the pessimistic fly on the wall, but are you prepared in case it takes a while to find renters?
    Also I haven’t been to Charlotte. Is it really that nice that you would consider retiring there?

  2. Hey, Gina, sorry about the late response, but I’m sure that you understand since you knew that I was in Cancun for the last week or so.

    To answer your question, I would never purchase a home without knowing that I could handle the $1000 mortgage payment with or without tenants. That’ll be financial suicide. So yes, I am well prepared to pay the extra $1000 with no problem. But, hopefully it’ll be a while before I have to worry about this issue anyway. For the first three years, I will be the tenant. And hopefully before I move in 3 years, the home will be paid in full.

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