Real estate investment has been very rewarding to many intelligent and strategic investors. Investors that have the patience to take the long view have been well rewarded for their patience and diligence.
Many people view the purchase of their personal residence as a “real estate investment”. Rich Dad, Poor Dad author Robert Kiyosaki has challenged this idea through the definition of the word asset. He defines an asset as something that pays you money during your ownership and a liability as something that costs you money while you own it. By this definition, a personal residence does not qualify as an asset as you are not paid for ownership.
As well, best selling author of I Will teach You To Be Rich, Ramit Sethi, has shared reasons for his personal views that buying a house is not always the best advice for a young working professional. Not the least of which is the “phantom costs” of insurance, taxes, and repairs associated with owning a home.
The analysis of both these men is sound. In general, a personal residence should not be purchased for investment purposes. There are certain circumstances where buying a personal residence can in fact work as a means of investment.
Buying a Residence with Investment as a Secondary Goal
For a young, working professional, buying a home and having other people help pay your mortgage can
be a way of investing. What do I mean? You buy a house with three bedrooms and rent the other two bedrooms out to two of your friends. Or buy a duplex live in one side and rent the other side out.
With most fixed-rate 15-year and 30-year mortgages, a portion of each payment is applied to the debt owed, the principal or principal balance. This increases your home equity. Equity is the value of your residence minus the total debts against your residence.
Home equity is a form of “forced savings”. Home equity is not easily spendable. Thus making a monthly payment towards the principal balance forces you to save a portion of each loan payment.
Having additional people to make your mortgage payment can provide you with extra cash for investment, spending, or to pay down your mortgage.
Using FHA 203(b) for First-Time Home Buyers
For the working professional using an FHA insured loan makes sense. The FHA 203(b) program allows eligible borrowers to qualify for up to 96.5% of the purchase price to be financed. These loans often have a slightly higher rate than a traditional mortgage, but offer the flexibility of a smaller down payment.
Most traditional lenders will look for at least 20% of the purchase price to be paid by the borrower. In high priced areas, like the San Francisco Bay Area, this can be a big hurdle to overcome.
FHA has stricter guidelines for what types of homes qualify. Homes have to be in livable condition and have been owned by the previous owner for at least 90 days.
A Charted Course
To apply this strategy a charted course is needed to avoid trouble.
- Make sure your credit is in order. Pay your bills on time. Don’t run up to much credit card debt. Spend less than you earn.
- Collect adequate savings for a “rainy day”. This should be 6-8 months of reserves. One month of reserves would cover your proposed monthly mortgage, monthly utilities, any other debt payments, food, insurance, etc. Lenders like to see that you have funds available should you be unable to work or are laid off to continue to pay your monthly obligations. It will also help you avoid anxiety and worry.
- Determine how much house you can afford based on your current income. A single professional earning $60,000 per year would bring home about $3,600 after taxes each month. When calculating the amount you can afford to pay you should exclude any payments from your proposed roommates. You want to be sure you can make the payments without the roommates, should they leave for any reason.Lenders usually require that housing costs should be no more than 28% of your gross monthly income. (It may be wiser to limit yourself to 25% of your take home pay.) Using the lender ratio would provide for a monthly housing costs of about $1,400 including taxes and insurance.Assuming property taxes of approximately $275 per month and insurance of $85 per month leaves $1,040 per month for loan payments. Using an interest rate of 6.50% per year our young professional could afford a house worth $164,539 on a 30-year mortgage and $119,388 on a 15-year mortgage.
- Save for a down payment and closing costs. Notice this is separate from reserves. Once you make the down payment, you won’t have it for reserves. Plan to save between 5% -10% of the purchase price of the home. Each housing transaction has additional costs relating to transfer tax, title insurance, and escrow. Our young professional should save between$8,227 and $16,454.
- Find and purchase your home
The whole strategy will take a number of months to accomplish and building equity in your home will take years. This is not a get rich quick strategy. This is taking the long view, charting a course, and diligently following it till you get the desired results.
The FHA 203(b) mortgage can be used to purchased up to a 4-unit property. Using the same principal you could attempt to purchase a building that will generate income from the other units.
A Note About Investing
The key to any investment strategy is not to risk more than you can afford to lose. If losing your down payment is more than you can afford to lose mentally, emotionally, or financially do not risk it by investing. Each investor has their own risk tolerance. For some investors, they can only tolerate the risk that a CD at the bank offers. Others are willing to take bigger risks. Find the level of risk that is suitable for you and invest accordingly.
(House Photo: james.thompson)