Should I Buy a House?

Whoever said “buy land because they aren’t making more of it,” didn’t think about the Metaverse. Checkmate, boomer.

If you are thinking about buying a house but are just joining us, check out Part 1 and Part 2 of this series. As a summary, Part 1 detailed that buying a home is expensive, like really expensive. Part 2 explained how the renting versus buying argument is not as simple nor conclusive as many people want it to be. Today, I am going to be talking about some options after you’ve already bought one. Part 3 is called “Beyond the Purchase.”

Once you own your house, you have several options to extract some additional value from it. You can do a cash-out refinance, open a home equity line of credit (HELOC), rent it out, or sell it and buy another with a 1031 exchange.

Refinance - A Potential Home Run

Let me start by saying, never assume you will be able to refinance for a lower rate. The Federal Reserve has one job: keep inflation at 2%. All the talk of the “soft landing” in terms of a recession is just fancy speak for “we will lower inflation even if that means starting a recession.”

But let’s assume in ten years inflation is under control and interest rates come down slightly, you may have an opportunity to do a cash-out refinance.

Scenario: You bought a $500,000 house at a 7% interest rate and put $100,000 (20%) down. Your monthly payment is around $3,100.

By 2032 (9 years later), you’ve paid off about $50,000 from your principal, and, assuming 4% appreciation each year, your home is now worth a little more than $700,000. You have $350,000 in equity in your home! Exciting! But accessing that equity is challenging.

If you opt for a cash out refinance, the most cash you will be able to get is around $195,000. Why not all 350? No lender will give you more than 80% loan to value (unless it’s a VA loan) meaning the biggest loan you could get on a $700,000 house is $560,000. Since your remaining loan balance is $350,000, you still have to account for all the financing costs which are almost identical to closing costs bringing your available cash to around $195,000. That’s a lot! But now you’ve reset your mortgage and have a new monthly payment of about $4,300 if your interest rate didn’t change. If it goes to 5%, your monthly payment is around $3,600.

You can change the size of your loan to lower your monthly payment and how much cash you get. However, I will die on the argument that refinances only make sense if you can get a much lower interest rate. You can’t control interest rates so the “equity” you have in your house is really not that great.

HELOC - Tread Carefully with Variable Rates

A Home Equity Line of Credit is a way to access the equity I just talked about without refinancing. However, a HELOC has some big baggage: variable interest rates.

A HELOC is a line of credit on the equity in your house. So in the same scenario, you could potentially get $200,000. Most HELOCs stay at the 80% loan to value (LTV), but some companies will go higher than that. They also have smaller financing fees.

Once you open the HELOC, you can withdraw as much or as little as you want up to your limit during the funding period. This adds a little flexibility and freedom. Let’s say you’re using a HELOC to build a new kitchen, you can withdraw in increments to pay for the improvements and minimize monthly payments during construction. Once the funding period closes (2-10 years), your rate goes from variable to fixed. Fingers crossed interest rates are low! During that funding period, your rate is variable which makes budgeting and saving difficult.

HELOC rates are also going to be higher than mortgage rates. This is because of the higher risk associated with additional loans on homes. Also, the line of credit is still secured by your home. So if you default on a HELOC, you can lose your house.

Rent It Out - Get that Not-So-Passive Income

Renting out your house is a great way to add some “passive” income. I put passive in quotes because on the passive income scale, renting out your home can be very active at times. The first step is checking for comparable rentals (rental comps) to see what you can expect in rent. If you are only able to get your monthly mortgage payment in rent, that is a risky decision given all the additional costs I talked about in part 1. If you are able to rent it for 50-75% more than your mortgage, you are looking at an awesome investment opportunity. The next decision is to use a property manager or self manage. Most property managers charge 8-10% of the monthly rents. Then, they add a bunch of different fees like showing fees, new lease fees, maintenance fees, and more. If you want to self manage, that means even more time spent finding renters, coordinating maintenance, and dealing with other problems.

Renting out can be a fantastic option with your house, but the numbers have to work. If this is a route you go, I’d recommend increasing your emergency savings because you’ve probably doubled the amount of A/C units you may have to replace.

1031 Exchange - Tax Deferred Growth

This one is super simple, you just have to exchange your house at exactly 10:31 AM, and you pay no taxes.

Okay, it’s slightly more complicated than that. The 1031 exchange applies to investment properties or a primary residence that you have lived in for less than two years. If you are selling your primary residence and lived in it for at least two out of the past five years, you will pay $0 in taxes for any profit under $250,000 for single filers and $500,000 for joint filers.

If you are selling your rental property to buy another rental property, the 1031 exchange is an awesome way to delay your tax bill. The 1031 exchange allows you to take profits from an investment property and invest them into a “like-kind” property without paying taxes on those profits. The 1031 exchange does not eliminate your tax bill, it delays your tax bill.

When you buy property, you have a cost basis. This is the purchase price of the home plus any improvements (lots of IRS rules on that). When you sell your home, you calculate your profits by taking the sale subtracted by your cost basis. In a 1031 exchange, the profits you use to buy a new property lower your cost basis. This means when you sell the second home, you have to pay taxes on the new profit plus the profit from your first sale. For example:

You buy a $500,000 house; your cost basis is $500,000.

You sell it for $600,000.

Your profit is $100,000.

You take that profit to buy a newer $500,000 house with a 1031 exchange; your cost basis is $400,000.

You sell it for $600,000.

Your profit is $200,000, and the tax man is knocking.

This is why a 1031 exchange is a tax deferral, not tax reducer. The IRS rarely lets you get away from taxes. The tax man is always watching. However, there is no rule on how many 1031 exchanges you can do. You can keep rolling profits into new investments and never pay the bill.

This concludes this home buying series! From costs to profits, I tried to give a well rounded perspective on everything involved in home buying. If nothing else, please remember that home buying is very personal. You can be extremely wealthy and only rent, or you can be extremely wealthy and always buy. It just depends on what you want to do.

Call to Action

Regardless if you are interested in buying your first home or third investment property, I’d recommend connecting with a local real estate agent and forming a relationship. They can set you up with automatic emails on the current MLS listings so you can start to see prices and options. The perfect investment property or home isn’t waiting for you to be ready!

What We’re Reading/Listening To:

Podcast: The Journal - How Apple Lost to the EU. If you are team iPhone, like me, and are frustrated with yet another charging connector switch, this podcast goes into why Apple made this change. Spoiler alert: it wasn’t because Tim Cook wanted to stop making billions by selling and licensing the proprietary “lightning connector.”

Debrief on Deck

Next week, Mike is going to talk about dollar cost averaging versus lump sum. Another spoiler alert: Mike and I disagree with some of the finance hawks about what the best option is. Third spoiler alert: the numbers agree with Mike and I.

As always, please reach out to us with any questions or comments you have. You can reply directly to this email or find us on social media (X (formerly Twitter) and Instagram).

Until then, stay the course.

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