Pay Down First Home, Convert to Rental?

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So you may be wondering, how did I go from wanting to put only 10% down to thinking about 15-year mortgages? Well, mostly idle mind exercises since I still have about a year before purchase. But here’s my idea. I would like to get an investment property somewhere down the line, but the gap between rent and most mortgage payments is just enormous. I would really like to get a cashflow positive property, where the rent covers all my expenses (mortgage, insurance, maintenance).

So what if we buy a smaller 2-bedroom place, and get a 30-year mortgage on it (instead of the 15-year as I was thinking), but pay it down as fast as you can (like a 15-year). After 5 years or so, we could check out current rents. If they are high enough, we could just leave the 30-year mortgage on it, rent it out, and buy a second house. If they aren’t we should have paid down the principal enough to be able to refinance the loan to a low-enough mortgage payment.

I know that there are tons of unknown variables like future rents, future interest rates, our future income… But this seems to be a pretty safe bet. If all else fails, we just have to sell the house and ‘trade up’ to a bigger one when we have kids like most people do. Poke holes in idea as needed 🙂

Another option would just to try to find a $150,000 place somewhere really outside the city and get an investment property loan on it, which usually has higher interest rates, and try to rent that out. There’s also the idea of buying a duplex and renting out one side while living in the other. I don’t know if that would make sense with current rent-to-mortgage ratios though.

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  1. Never ever never Pre-Pay a mortgage! Pay the minimum payments and invest the rest – pre-paying a mortgage converts investible money into “Dead” money that loses inflation each year. Your house will appreciate, and you will recieve rent regardless of your balance on your mortgage – so don’t make the mistake of thinking pre-paying is a good thing. As part of your “Cash Flow Positive” calculation, include the money that you would have prepaid into the mortgage and invest it in the market – maybe REITs if you want to keep it in real estate.

    Loan-wise the best product I know of is a 30 Year Fixed Interest Only loan. The first 15 years are interest-only payments, the next 15 years are amortized just like a 15 year loan – the interest rate is fixed for the whole 30 years. Invest the principle you would have been paying for the first 15 years (of a normal 30 year fixed) – that way when ther last 15 years come around you are making bank off your would be priciple payments (15 years of payments compounding!) and you can afford the higher last 15 year principle payments.

  2. I would have to agree with JT. You want as little down as possible. Why pay off a mortgage early? What does it do to your net worth?

    Small business owners spend all day trying to figure out how to get cash OUT of there business and here you are trying to lock cash IN your business.

    Every financial decision should be based it’s effect on your Net Worth.

  3. Decisions, decisions! Will shopping for a mortgage be easier than selecting a home to bid on? I’m not so sure. 🙂

    Good luck!

  4. Ive had similar thoughts, but I couldnt justify the opportunity cost to owning a home with a bunch of equity and renting it out to make a little money. Let’s say you only owe 200k on a 500k house in the SF bay area, and therefore you can rent it out for positive cash-flow. This means you pocket 500/month on a 300k investment. The only way that would pencil would be steep appreciation in coming years to get huge equity gains. It seems improbable that equity gains like weve seen the last 10 years will be possibe in the next 10-years. If I had 300k of equity, which I do, and I didnt want to live in my house anymore, Id just sell it and reinvest.

    I have a friend who lives in PA, 5-blocks from work, in a small 3/2 house probably worth ~2M. He rents for 1700/mo. For that rent, he lives in the heart of PA, walks to work, schools his kids in the PA school system, and gets all the other benefits of location. He does not get equity, but he saves approximately 5-6k/month not paying the mortgage on the value of the home he lives in. So, he trades non-liquid home equity for 50-60k/year cash money. In effect, the owner is subsidizing my friend’s quality of life. I commute 30-mins to work, and if I could get that same set up, I might sell my house, reap the equity, and rent in PA. So, Jonathan, if you do buy a house in PA, and want to rent it for cheap (bay area market rents), let me know, Id be happy to have you subsidize a good standard of living for myself.

  5. Nony-Mouse says

    I have about $250K saved up and was thinking of putting $200K towards downpayment on a house that costs around $300K. Do you think this is advisable? I can quite easily save up another 25K by end of the year.

  6. what about a cash our refinancing after you’ve put a lot into equity.

  7. “Decisions, decisions! Will shopping for a mortgage be easier than selecting a home to bid on? I?m not so sure. :-)”

    I know! I’ve been trying to keep myself from looking at houses. There’s no chance they’ll still be on the market in a year and who knows what will happen to prices. All I can do is continue to save and hope for the best.

    Someone said to write about looking for foreclosures, maybe that’s something to look into.

  8. JT and Wes – I disagree with you to not pay off the mortgage early. Every month you give away lots of money to the bank in interest payments. These payments prevent your mortgage principal from going down so they DO have a negative effect on your net worth. Net worth grows faster with less interest paid to the bank each month.

    Am I missing something?

  9. This is what we did. My wife and I bought a 2-family house, lived in one unit and rented the other. The rent covered over half the expenses. We saved for 3-1/2 more years and moved into a single family and rented both units. The rents covered the expenses and provided a small positive cash flow. Real estate prices were flat for a few years but as you know recently have taken off. This is what I have noticed about real estate, many years of no or little price appreciation, then a brief period of rapid appreciation. Both houses are now worth over twice what we paid. If I were you I would look at fairly new duplexes. That way the maintenance expenses will be low and the rents are better than with older up/down 2-family units,

  10. Never ever never Pre-Pay a mortgage! Pay the minimum payments and invest the rest – pre-paying a mortgage converts investible money into ?Dead? money that loses inflation each year.

    Well, where are you going to invest that borrowed money? How about a guaranteed 6.5% investment (also known as pre-paying your mortgage)? There are certainly situations where you wouldn’t want to pre-pay the mortgage, but there’s nothing wrong with doing so.

    As for foreclosures, you don’t need to waste your time looking into those. There are professional real estate folks who are already on top of them, you don’t stand a chance.

  11. I strongly disagree with JT and Wes’s notion that you should never pay down debt more than obligated. Debt is debt is debt, it’s your liability. No matter how fancy the world of finance is, it’s still the same old fashioned world of borrow and lend. Of course you should not focus only of paying of debt, but paying off debt is always one of the top priorities of anyone’s financial life.

  12. Here is something else to consider when choosing a mortgage. If you do decide to live in the home a few years before renting it out – an ARM can give you some flexibility. After the initial locked rate expires, the loan typically changes over to a 1 yr adjustable.

    Let’s assume you get a 5/1 ARM. In this case, you get your initial rate locked in for the first five years. Every year after the rate adjusts. The benefit, however, is that during each annual rate adjustment – the total loan amount is recalculated as well. Meaning that if the rate remains unchanged and you have paid down additional principle, your monthly payment will decrease.

    Essentially what this gets you is a free re-finance without having to pay any closing costs. Granted you still take on the risks of dealing with rising interest rates, etc.

    Another option that might be a possiblity is a 5/5 ARM. This at least lengthens the re-adjustments to a 5 year cycle instead of annually. Not sure how hard it is to find lenders for these.

  13. Does anyone know how to get foreclosures? I know professional investors are after them, but in a sliding real estate market, no professional would buy a foreclosure at 70% value – whereas that 30% discount would be great for individual buyers like us.

    Can you hire a good real estate professional, offer higher fee and ask them to look for a foreclosure that meets your demand? Will this work?

  14. Jonathan, you’ll be happy to know I’m about to close on my first house! I probably wouldn’t be able to move out and make a profit from renting it, for a few years. I think the rent-to-mortgage gap is high in the area to which I am moving. But then again, I haven’t checked.

    Well, I know we are in very different locations, but when you start looking at houses let me know if you need any advice.

  15. I agree with JT. This concept is called house rich/cash poor. Why tie up your cash in an investment that pays between 6% to 7% interest and cannot be liquidated until the property is sold or refinanced? A property will appreciate at the same rate whether you have 50% in equity, 10% in equity or 0% in equity.

    Given that you can find an investment vehicle that pays the same rate (or higher) as your mortgage (i.e.: 30 year loan at 6.5% means that you have to find a 6.5% or better investment), it is far better to DIVERSIFY your investment. The return on your investment can be used to offset the interest from the mortgage loan.

    For us, we have taken all the equity out of our house and finance the entire loan 100%. Using the equity gain from appreciation, we’re investing it at a higher rate. We’re applying the concept of “other people’s money” to create assets. We gain liquidity for other needs (i.e.: emergency medical), a higher rate of return for our money, etc… The ideal situation for us is to never “own” property. We have the title to property to benefit from appreciation but try very hard to limit the equity invested in the property.

  16. It’s worth looking at houses so you guys can see what’s out there, what you like, don’t like. You’ll be able to spot a good deal better if you know what’s on the market and what you really are willing to compromise on when buying a home. Being able to know when to pounce is important. I’d stroll some open houses for a bit, get a feel for what’s out there now so you can compare them with what you’ll see when you’re ready to buy.

    I think I didn’t shop around quite enough, but I’m still happy I have an affordable place above all else. I was pre-approved for $60K more than my purchase price, but I am able to eat and dress in style, pay down other debt and enjoy life all with a smaller mortgage payment.

    Above all else, get something you can afford on a monthly basis. All these folks getting pinched by their ARM’s make me cringe. Had they bought smaller homes, they might not be feeling the pinch so hard right now. I’m so glad I didn’t buy a place for the full pre-approved amount. I’d probably be suffering under some crazy interest only ARM and panicking over interest rates if I did.

  17. There is not right answer out of the box – use this website to help decide what is best for you.

  18. BizBroker,

    Your method is risky, because if you have an unforseen event, such as an illness, job loss, disability, you are 100% leveraged, without income. That sets up a case where you would have to tap into your “investments” while you still owe 100%.

    That is a brew for disaster.

  19. I have to disagree with Dean. There are good deals to be had with foreclosures. You can usually find a realtor that specializes in deals that are foreclosures or pre-foreclosures (people who are falling behind in their payments). My dad has done well with these, he owns 3 houses that required only cosmetic clean-up (carpet needed a really good cleaning, some painting), that he’s renting cash-flow positive (in McKinney, it’s near Dallas). The challenge isn’t in finding houses that are foreclosures, it’s in finding ones that aren’t too messed up. But, just going and actually looking at them solves that problem. He also had quite a bit of almost instant equity in the houses upon just cleaning them up.

    Also, if you are considering buying a property that will be a rental, pay very close attention, and ask realtors, what rents fast and what’s in short supply. In Dallas and the surrounding area, one of these markets happens to be houses that are 4+ bedrooms, which are also some of the easiest houses to find foreclosure deals on.

  20. bigmouth: You said it’s your “liability”. That’s a balance sheet word. What’s the other side of the balance sheet? Assets. Throw in cash flow and that’s how you grow your net.

    Let’s look at it by borrowing from calculus: what if your mortgage carried a 0% interest rate. What would you do? Still pay off the entire mortgage? Of course not – the opportunity cost is too high, i.e. competing investments are offering a higher return.


  21. The question here is having the cash when an opportunity arises. If you have an opportunity that will pay off more than the interest of the mortgage, then great, put money into that. But if you don’t, and that money will just sit in a normal bank account, or worse, be spent on expenses, put it into paying down the house.

    I personally like to think of the equity in the house as a bank account. Set up a mortgage, and a revolving credit against the house. Then pay down the mortgage as much as possible, and only when a clear opportunity arises, do you dip into the revolving credit, simply by writing a check.

    You get the best of both worlds. A focused goal to pay down your mortgage, but still have the flexibility to drawn upon your equity for other business opportunities.

    Sadly, I never set up a revolving credit against my house before I had to sell it (moved out of state, bad tenants, etc). If anyone knows more about this, I still would love to learn.

  22. You don’t have to beat your mortgage rate of 6.5-7% you have to beat your mortgage rate minus the tax writeoff which for an interest only loan is 100% of the payments so say 5% is the rate to beat.

    If rates were to shoot up to 10% I could see maybe paying down a mortgage, but if the cost of money is cheap – invest it over the long term. You don’t try to get to retirement by putting all your money in bonds – why would you do this with your house (by putting the money towards a cheap loan)?

    If you are in the Bay Area watch/tivo Rob Black and Your Money on KRON 4 at 10 am every day – he has a range of guests that talk about similar topics to this blog.

  23. If the gap is massive between rent and mortgage and you have to think up creative ways to make a rental property seemingly “profitable” – that is telling you that economically it is not profitable… and other investments would be better.

  24. JT and Wes are almost right (my opinion). It really depends on the rate you borrow at. If you are in a 4-5% mortgage, then paying it off might not be the best option. If you have a rate in the 6% and up range, it starts to make sense to pay it down faster. And also, if it’s about increasing your net worth, the faster you pay down the house, the faster your networth grows all other things remaining unchanged.

  25. JT, don’t forget that you have to pay tax on your investment return, so you have to compare the after tax return on your investment vs the “after tax writeoff” of your mortgage interest to make a sound comparison.

    Reality check: what should be invested in today’s market, using the available cash (which would have been paid to mortgage)?
    CDs? The average high yield account is abt 5.3%, that is abt 3.7% after tax. Stock and Funds? Recently the stock market is not doing well. The only two option as far as I can see (I am just a beginner in investment) is real estate, which can be risky, and long term investment in equity.

  26. Beware also of renting property, I haven’t seen anyone post anything like this so here goes:
    It is very difficult to find good renters. Most of them treat properties like crap or worse you have one of the horror stories happen to you where people grow pot in the walls and you have to gut the house to remove the drugs or where they just don’t pay the rent and you have to get them out – the law is on the side of the renter NOT the landlord. If you have to take people to court to get them out of your property for not paying rent you will generally be out several grand…

    On lenders and finding a loan: Work with a lender that you think is a good person – don’t just look for the best deal – it’s very common for lenders to change your rates or loans terms a couple weeks before you’re supposed to close so they can get a better commision.

  27. First, I strongly disagree with JT and Wes. By paying your mortgage early, you are in essence guaranteeing a return on that money by whatever your mortgage rate is, because that is money you won’t be paying interest on from then on. Yes, it does tie up the money. Think of it as money you shouldn’t touch, like your 401k, at least until you sell your home. If you are OK doing that, then I see no problem.

    Think of it this way. If I have a 5.75% mortgage and pay extra every month, that’s just like buying a long term CD or bond at 5.75%, but when I sell the home, the return on that money is tax free!

    As to buying and renting a home, I was looking at that very option recently, being in the Silicon Valley of California, I just couldn’t make it work. The home prices are way too high here for rents to cover it. Even putting 20% down and getting an adjustable rate interest only loan still wouldn’t cut it.

    The only way I’ll be able to execute this strategy is to wait until rents can cover my current mortgage and taxes, and then buy another home and move into it, while renting my present home. I’m guessing that’s still about 5 years off.

  28. CS> what should be invested in today?s market

    The same thing that always should be invested in over the Long Term – the stock market using a diversified portfolio of low cost index funds and mutual funds. Worrying about short term performance and trying to time your investements is a fools errand. Put money into the market over time and the market goes up 7 out of 10 years and average return is 11% (don’t count on that per se, but say 9% is a reasonable assumption – OVER TIME, sure short term recessions happen but you don’t make long term investing decisions based on the recession boogeyman) .

    Kevin: When you sell your home, taxes are based on your capital gain from when you bought, not based on your current mortgage balance – so would you prefer to have money come back to you with NO return (although it did save you some tax-deductible interest payments), or would you prefer to have that money invested generating a great return and some capital gains taxes – the decision is easy for me….

    The other factor worth mentioning is that Charles Manson could move in next door or we could have an earthquake – your low mortgage balance wouldn’t mean crap at that point (you might not be able to get your money back when selling or trying to refinance). Whereas your diversified investments would still hold their value. Why put your cash into one big basket that you may not be able to get it out of? Granted this scenario isn’t the most likely of outcomes, but it is possible. Again for me, maximizing return and limiting risk are what I try to base my decisions on.

    If you do own rental proprty its worth looking at putting it into a corporate structure to protect your liability – getting sued, etc.

  29. I wish that we would have been more aggressive about acquiring properties before we had a child. I didn’t realize how lucky we were to have that kind of cash flow. Without kids, and if you had two incomes, you could easily do what you are talking about.

    Now that we’ve purchased our second home, I think we will try to aggressively pay it down while we enjoy it and then at some point, use it as a cash flow positive property. Since we bought it unfinished and have some resources to finish it cheaply, we should be able to be cash flow positive within a couple years.

  30. Back to one of the original ideas…
    All other pros/cons aside, if you can use a homeowner mortgage to finance an investment property, you are saving a great deal of downpayment/interest over a commercial loan. (I think the standard lender requirement is to live in the house for at least 2 years, though noone really checks). of course, there are many other factors like the cost of real estate vs. market rental rates. Here is what I recently did: I purchased a downtown (birmingham, al) loft condo 2 years ago and financed 80% of the purchase price of $108K. 1.5 years after purchase, I rented the condo for $895/mo. and purchased a 2/1 house for $165K (also close to downtown). Now the condo pays about $200/mo positive cash flow (over the note, condo fee, taxes, insurance). I have a 30 year fixed at somewhere around 5.625% and plan to not prepay anything. Property values here have appreciated rapidly recently (just as other areas in the country) and both areas that I own are great neighborhoods for appreciation. I would say the market value for condo is now around $165K. I don’t if this helps anyone, but it is a real life example. I also know that a lot of markets around the country would not allow this to happen because of rental vs. prop. value rates, prop. taxes, etc.

  31. We are doing that right now! I think it is a wonderful idea actually.

  32. There always pro and cons to Real Estate Investment….

    However, I personally cannot think of any other investment that would let you take up to $500K in capital gains TAX FREE (for married couple) after 2 years of personal use as primary residence plus 3 years of rental income (assuming positive cash flow) —– this alone makes investment in Real Estate, in my humble opinion — the best vehicle to build Net Worth.

    In addition: my husband and I are strong advocates of 20% Down Payment to avoid PMI (private mortgage insurance) — which depending on mortgage amount — may add couple of hundreds of $$$ to montly payment — Therefore, anybody who has 100% mortgage has that extra cost to overcome as well…

    Besides, cashing out of equity process I saw mentioned a few time requires additional closing cost that increase cost basis and reduce profits….

    So, each individual situation is different …

  33. So many replies here are between 20% and 95% correct. Be careful.

  34. bigworm000 says

    I disagree with the paying down the mortgage thing. It can be good in some situations although i am just a newbie to investing. My plan is to buy a duplex for around 100k (prop is cheap here :P). I will pay off the mortgage in about 3-4 years using extra income. When i own the property 100% i will then rent it out and come up with about a 10k after tax profit each year. I will then (or probably sometime during the 3-4 year period) purchase another property for about 100k or so. Instead of 20k each year extra being put on the mortgage i will also use the 10k profit from rents from the first property. So the second property will be paid off even quicker. After doing this 4 times i would have 40k profit a year and 400k invested. 10% is a damn good return on money that is in essentially a risk free environment. So in this situation the sooner i get a mortgage paid off the sooner i can use the full income coming from the rents to reinvest. I am 26 now and investing like this will have me living good at 45 probably making more from rental property than at my current job.

  35. what I have learned from investing in real estate:

    1. your money, your research.

    2. do not take advice from non-investors about investing. they can offer opinions about your primary residence, but beyond that they have no place to speak.

    Good Luck.

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